The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Troy Information Technology Co., Ltd. (SZSE:300366) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Troy Information Technology Carry?
The image below, which you can click on for greater detail, shows that at September 2023 Troy Information Technology had debt of CN¥770.3m, up from CN¥495.4m in one year. However, because it has a cash reserve of CN¥326.8m, its net debt is less, at about CN¥443.6m.
How Healthy Is Troy Information Technology's Balance Sheet?
The latest balance sheet data shows that Troy Information Technology had liabilities of CN¥1.66b due within a year, and liabilities of CN¥19.9m falling due after that. Offsetting these obligations, it had cash of CN¥326.8m as well as receivables valued at CN¥1.61b due within 12 months. So it actually has CN¥259.2m more liquid assets than total liabilities.
This surplus suggests that Troy Information Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Troy Information Technology 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.
In the last year Troy Information Technology wasn't profitable at an EBIT level, but managed to grow its revenue by 35%, to CN¥2.2b. Shareholders probably have their fingers crossed that it can grow its way to profits.
Caveat Emptor
Despite the top line growth, Troy Information Technology still had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost CN¥117m at the EBIT level. Looking on the brighter side, the business has adequate liquid assets, which give it time to grow and develop before its debt becomes a near-term issue. But we'd want to see some positive free cashflow before spending much time on trying to understand the stock. So it seems too risky for our taste. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Troy Information Technology (1 makes us a bit uncomfortable!) that you should be aware of before investing here.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
