Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. As with many other companies Hengan International Group Company Limited (HKG:1044) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
Our analysis indicates that 1044 is potentially overvalued!
What Is Hengan International Group’s Debt?
The chart below, which you can click on for greater detail, shows that Hengan International Group had CN¥22.9b in debt in June 2022; about the same as the year before. But it also has CN¥24.5b in cash to offset that, meaning it has CN¥1.63b net cash.
How Healthy Is Hengan International Group’s Balance Sheet?
We can see from the most recent balance sheet that Hengan International Group had liabilities of CN¥24.8b falling due within a year, and liabilities of CN¥2.31b due beyond that. On the other hand, it had cash of CN¥24.5b and CN¥4.89b worth of receivables due within a year. So it actually has CN¥2.26b more liquid assets than total liabilities.
This short term liquidity is a sign that Hengan International Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Hengan International Group boasts net cash, so it’s fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Hengan International Group if management cannot prevent a repeat of the 32% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hengan International Group can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. While Hengan International Group has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Hengan International Group generated free cash flow amounting to a very robust 90% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company’s debt, in this case Hengan International Group has CN¥1.63b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 90% of that EBIT to free cash flow, bringing in CN¥3.7b. So we are not troubled with Hengan International Group’s debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Hengan International Group is showing 2 warning signs in our investment analysis , you should know about…
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.