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. 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 note that China Mengniu Dairy Company Limited (HKG:2319) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Mengniu Dairy Carry?
As you can see below, China Mengniu Dairy had CN¥13.7b of debt at June 2019, down from CN¥14.7b a year prior. However, its balance sheet shows it holds CN¥17.1b in cash, so it actually has CN¥3.33b net cash.
A Look At China Mengniu Dairy's Liabilities
According to the last reported balance sheet, China Mengniu Dairy had liabilities of CN¥35.0b due within 12 months, and liabilities of CN¥7.09b due beyond 12 months. On the other hand, it had cash of CN¥17.1b and CN¥6.48b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.5b.
Given China Mengniu Dairy has a humongous market capitalization of CN¥107.5b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, China Mengniu Dairy boasts net cash, so it's fair to say it does not have a heavy debt load!
Another good sign is that China Mengniu Dairy has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. 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 China Mengniu Dairy'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While China Mengniu Dairy 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, China Mengniu Dairy recorded free cash flow worth a fulsome 80% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While China Mengniu Dairy does have more liabilities than liquid assets, it also has net cash of CN¥3.33b. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in CN¥1.5b. So is China Mengniu Dairy's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in China Mengniu Dairy, you may well want to click here to check an interactive graph of its earnings per share history.
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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