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.' 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 note that Hwa Create Corporation (SZSE:300045) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Hwa Create's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2024 Hwa Create had debt of CN¥73.4m, up from CN¥43.8m in one year. But it also has CN¥318.1m in cash to offset that, meaning it has CN¥244.7m net cash.
A Look At Hwa Create's Liabilities
According to the last reported balance sheet, Hwa Create had liabilities of CN¥611.9m due within 12 months, and liabilities of CN¥123.2m due beyond 12 months. Offsetting these obligations, it had cash of CN¥318.1m as well as receivables valued at CN¥660.6m due within 12 months. So it can boast CN¥243.7m more liquid assets than total liabilities.
This surplus suggests that Hwa Create has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Hwa Create has more cash than debt is arguably a good indication that it can manage its debt safely.
Although Hwa Create made a loss at the EBIT level, last year, it was also good to see that it generated CN¥16m in EBIT over the last twelve months. 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 Hwa Create will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Hwa Create 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. Happily for any shareholders, Hwa Create actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Summing Up
While it is always sensible to investigate a company's debt, in this case Hwa Create has CN¥244.7m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥24m, being 150% of its EBIT. So is Hwa Create's debt a risk? It doesn't seem so to us. 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. We've identified 1 warning sign with Hwa Create , and understanding them should be part of your investment process.
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.
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