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. 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, Ausnutria Dairy Corporation Ltd (HKG:1717) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ausnutria Dairy's Debt?
As you can see below, at the end of December 2019, Ausnutria Dairy had CN¥922.8m of debt, up from CN¥870.4m a year ago. Click the image for more detail. But on the other hand it also has CN¥1.67b in cash, leading to a CN¥751.8m net cash position.
A Look At Ausnutria Dairy's Liabilities
We can see from the most recent balance sheet that Ausnutria Dairy had liabilities of CN¥3.01b falling due within a year, and liabilities of CN¥1.27b due beyond that. On the other hand, it had cash of CN¥1.67b and CN¥514.8m worth of receivables due within a year. So its liabilities total CN¥2.09b more than the combination of its cash and short-term receivables.
Since publicly traded Ausnutria Dairy shares are worth a total of CN¥18.8b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Ausnutria Dairy also has more cash than debt, so we're pretty confident it can manage its debt safely.
In addition to that, we're happy to report that Ausnutria Dairy has boosted its EBIT by 56%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ausnutria Dairy 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Ausnutria Dairy 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. In the last three years, Ausnutria Dairy's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Although Ausnutria Dairy'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¥751.8m. And it impressed us with its EBIT growth of 56% over the last year. So is Ausnutria Dairy's debt a risk? It doesn't seem so to us. 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 Ausnutria Dairy that you should be aware of.
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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