We Think Vongroup (HKG:318) Can Manage Its Debt With Ease
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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Vongroup Limited (HKG:318) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for Vongroup
What Is Vongroup's Debt?
The image below, which you can click on for greater detail, shows that Vongroup had debt of HK$25.3m at the end of October 2019, a reduction from HK$27.2m over a year. But on the other hand it also has HK$80.4m in cash, leading to a HK$55.1m net cash position.
How Healthy Is Vongroup's Balance Sheet?
According to the last reported balance sheet, Vongroup had liabilities of HK$35.1m due within 12 months, and liabilities of HK$849.0k due beyond 12 months. On the other hand, it had cash of HK$80.4m and HK$56.8m worth of receivables due within a year. So it actually has HK$101.2m more liquid assets than total liabilities.
This surplus liquidity suggests that Vongroup's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that Vongroup has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Vongroup has boosted its EBIT by 37%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Vongroup's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Vongroup 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. During the last two years, Vongroup burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Summing up
While it is always sensible to investigate a company's debt, in this case Vongroup has HK$55.1m in net cash and a strong balance sheet. And it impressed us with its EBIT growth of 37% over the last year. So we don't think Vongroup's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Vongroup is showing 4 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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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