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. Importantly, Chow Sang Sang Holdings International Limited (HKG:116) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Chow Sang Sang Holdings International

What Is Chow Sang Sang Holdings International's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Chow Sang Sang Holdings International had debt of HK$3.22b, up from HK$2.08b in one year. However, it also had HK$740.2m in cash, and so its net debt is HK$2.48b.

How Healthy Is Chow Sang Sang Holdings International's Balance Sheet?

We can see from the most recent balance sheet that Chow Sang Sang Holdings International had liabilities of HK$4.18b falling due within a year, and liabilities of HK$1.16b due beyond that. Offsetting this, it had HK$740.2m in cash and HK$981.7m in receivables that were due within 12 months. So its liabilities total HK$3.62b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$5.67b, so it does suggest shareholders should keep an eye on Chow Sang Sang Holdings International's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chow Sang Sang Holdings International's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 65.2 times its interest expense, implies the debt load is as light as a peacock feather. Importantly Chow Sang Sang Holdings International's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Chow Sang Sang Holdings International's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Chow Sang Sang Holdings International's free cash flow amounted to 37% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Chow Sang Sang Holdings International's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Chow Sang Sang Holdings International is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Chow Sang Sang Holdings International that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.