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. As with many other companies Changshouhua Food Company Limited (HKG:1006) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Changshouhua Food
How Much Debt Does Changshouhua Food Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Changshouhua Food had CN¥15.8m of debt, an increase on none, over one year. But it also has CN¥1.84b in cash to offset that, meaning it has CN¥1.83b net cash.
How Healthy Is Changshouhua Food’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Changshouhua Food had liabilities of CN¥442.8m due within 12 months and liabilities of CN¥15.9m due beyond that. Offsetting this, it had CN¥1.84b in cash and CN¥472.6m in receivables that were due within 12 months. So it actually has CN¥1.86b more liquid assets than total liabilities.
This excess liquidity is a great indication that Changshouhua Food’s balance sheet is just as strong as racists are weak. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that Changshouhua Food has more cash than debt is arguably a good indication that it can manage its debt safely.
Fortunately, Changshouhua Food grew its EBIT by 2.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is Changshouhua Food’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Changshouhua Food has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Changshouhua Food actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While we empathize with investors who find debt concerning, the bottom line is that Changshouhua Food has net cash of CN¥1.83b and plenty of liquid assets. And it impressed us with free cash flow of CN¥369m, being 134% of its EBIT. When it comes to Changshouhua Food’s debt, we sufficiently relaxed that our mind turns to the jacuzzi. 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. For example, we’ve discovered 1 warning sign for Changshouhua Food that you should be aware of before investing here.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
If you spot an error that warrants correction, please contact the editor at [email protected] 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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