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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 can see that Palace Banquet Holdings Limited (HKG:1703) does use debt in its business. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Palace Banquet Holdings
How Much Debt Does Palace Banquet Holdings Carry?
The chart below, which you can click on for greater detail, shows that Palace Banquet Holdings had HK$57.3m in debt in March 2019; about the same as the year before. However, it does have HK$269.7m in cash offsetting this, leading to net cash of HK$212.4m.
How Healthy Is Palace Banquet Holdings's Balance Sheet?
We can see from the most recent balance sheet that Palace Banquet Holdings had liabilities of HK$158.4m falling due within a year, and liabilities of HK$30.5m due beyond that. Offsetting these obligations, it had cash of HK$269.7m as well as receivables valued at HK$10.8m due within 12 months. So it actually has HK$91.6m more liquid assets than total liabilities.
This excess liquidity suggests that Palace Banquet Holdings is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Palace Banquet Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
But the other side of the story is that Palace Banquet Holdings saw its EBIT decline by 5.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Palace Banquet Holdings'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.