Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Hymson Laser Technology Group Co.,Ltd. (SHSE:688559) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.
What Is Hymson Laser Technology GroupLtd's Debt?
The image below, which you can click on for greater detail, shows that at March 2024 Hymson Laser Technology GroupLtd had debt of CN¥3.30b, up from CN¥1.29b in one year. On the flip side, it has CN¥699.3m in cash leading to net debt of about CN¥2.60b.
A Look At Hymson Laser Technology GroupLtd's Liabilities
According to the last reported balance sheet, Hymson Laser Technology GroupLtd had liabilities of CN¥7.79b due within 12 months, and liabilities of CN¥632.2m due beyond 12 months. On the other hand, it had cash of CN¥699.3m and CN¥2.38b worth of receivables due within a year. So it has liabilities totalling CN¥5.34b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CN¥6.85b. 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.
Strangely Hymson Laser Technology GroupLtd has a sky high EBITDA ratio of 8.8, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Hymson Laser Technology GroupLtd's EBIT was down 38% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hymson Laser Technology GroupLtd'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hymson Laser Technology GroupLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, Hymson Laser Technology GroupLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Hymson Laser Technology GroupLtd to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. We've identified 2 warning signs with Hymson Laser Technology GroupLtd , 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.