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 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 China Jishan Holdings Limited (SGX:J18) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is China Jishan Holdings's Debt?
The chart below, which you can click on for greater detail, shows that China Jishan Holdings had CN¥307.8m in debt in March 2019; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.
A Look At China Jishan Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that China Jishan Holdings had liabilities of CN¥464.8m due within 12 months and liabilities of CN¥44.1m due beyond that. Offsetting this, it had CN¥5.93m in cash and CN¥10.1m in receivables that were due within 12 months. So it has liabilities totalling CN¥492.9m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥229.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt At the end of the day, China Jishan Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.8 times and a disturbingly high net debt to EBITDA ratio of 7.0 hit our confidence in China Jishan Holdings like a one-two punch to the gut. The debt burden here is substantial. Worse, China Jishan Holdings's EBIT was down 58% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Jishan 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, China Jishan Holdings recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
To be frank both China Jishan Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. After considering the datapoints discussed, we think China Jishan Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Over time, share prices tend to follow earnings per share, so if you're interested in China Jishan Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.