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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Zepp Health Corporation (NYSE:ZEPP) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Zepp Health Carry?
As you can see below, at the end of June 2021, Zepp Health had CN¥1.42b of debt, up from CN¥881.4m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥1.42b in cash, so it actually has CN¥1.43m net cash.
How Strong Is Zepp Health's Balance Sheet?
We can see from the most recent balance sheet that Zepp Health had liabilities of CN¥2.43b falling due within a year, and liabilities of CN¥1.09b due beyond that. Offsetting this, it had CN¥1.42b in cash and CN¥1.34b in receivables that were due within 12 months. So it has liabilities totalling CN¥767.8m more than its cash and near-term receivables, combined.
Zepp Health has a market capitalization of CN¥3.80b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Zepp Health also has more cash than debt, so we're pretty confident it can manage its debt safely.
It is just as well that Zepp Health's load is not too heavy, because its EBIT was down 64% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zepp Health can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Zepp Health 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 three years, Zepp Health produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Zepp Health's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥1.43m. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in CN¥73m. So we are not troubled with Zepp Health's debt use. 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 Zepp Health is showing 4 warning signs in our investment analysis , and 1 of those is significant...
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.
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.
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