Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that E-Commodities Holdings Limited (HKG: 1733) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, many companies use debt to finance their growth without negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest review for E-Commodities Holdings
How much debt do E-Commodities Holdings carry?
As you can see below, at the end of June 2021, E-Commodities Holdings was in debt of HK $ 2.51 billion, up from HK $ 2.20 billion a year ago. Click on the image for more details. However, he has HK $ 907.4 million in cash to make up for this, which leads to net debt of around HK $ 1.60 billion.
How strong is E-Commodities Holdings’ balance sheet?
Zooming in on the latest balance sheet data, we can see that E-Commodities Holdings had HK $ 5.26 billion in liabilities due within 12 months and HK $ 312.9 million in liabilities beyond. On the other hand, he had HK $ 907.4 million in cash and HK $ 3.58 billion in receivables due within one year. Its liabilities therefore total HK $ 1.08 billion more than the combination of its cash and short-term receivables.
While that might sound like a lot, it’s not that bad since E-Commodities Holdings has a market cap of HK $ 2.09 billion, and therefore could likely strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
E-Commodities Holdings has a low net debt to EBITDA ratio of just 1.2. And its EBIT covers its interest costs 17.1 times more. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Best of all, E-Commodities Holdings increased its EBIT by 123% last year, which is an impressive improvement. If sustained, this growth will make debt even more manageable in the years to come. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in isolation; since E-Commodities Holdings will need income to repay this debt. So if you want to know more about its profits, it might be worth checking out this long term profit trend chart.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Fortunately for all shareholders, E-Commodities Holdings has actually generated more free cash flow than EBIT over the past three years. There is nothing better than cash flow to stay in the good graces of your lenders.
Our point of view
Fortunately, E-Commodities Holdings’ impressive interest coverage means it has the upper hand over its debt. But frankly, we think his total passive level undermines that feeling a bit. When zoomed out, E-Commodities Holdings appears to be using debt quite sensibly; and that gets the nod from us. While debt comes with risk, when used wisely, it can also generate a higher return on equity. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. Note that E-Commodities Holdings displays 3 warning signs in our investment analysis , and 1 of them is potentially serious …
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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