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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hong Leong Asia Ltd. (SGX:H22) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Hong Leong Asia
What Is Hong Leong Asia's Net Debt?
The chart below, which you can click on for greater detail, shows that Hong Leong Asia had S$844.8m in debt in June 2019; about the same as the year before. But on the other hand it also has S$1.46b in cash, leading to a S$617.3m net cash position.
A Look At Hong Leong Asia's Liabilities
According to the last reported balance sheet, Hong Leong Asia had liabilities of S$2.59b due within 12 months, and liabilities of S$367.4m due beyond 12 months. Offsetting this, it had S$1.46b in cash and S$1.89b in receivables that were due within 12 months. So it can boast S$402.1m more liquid assets than total liabilities.
This surplus strongly suggests that Hong Leong Asia has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Succinctly put, Hong Leong Asia boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Hong Leong Asia's EBIT dived 16%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Hong Leong Asia will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Hong Leong Asia may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Hong Leong Asia's free cash flow amounted to 50% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.