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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Hengan International Group Company Limited (HKG:1044) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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.
What Is Hengan International Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Hengan International Group had CN¥24.1b of debt, an increase on CN¥18.1b, over one year. However, it does have CN¥20.3b in cash offsetting this, leading to net debt of about CN¥3.76b.
How Strong Is Hengan International Group's Balance Sheet?
According to the last reported balance sheet, Hengan International Group had liabilities of CN¥23.7b due within 12 months, and liabilities of CN¥4.37b due beyond 12 months. Offsetting these obligations, it had cash of CN¥20.3b as well as receivables valued at CN¥5.29b due within 12 months. So it has liabilities totalling CN¥2.43b more than its cash and near-term receivables, combined.
Of course, Hengan International Group has a market capitalization of CN¥56.2b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Hengan International Group has net debt of just 0.67 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hot shot teppanyaki chef handles cooking. Fortunately, Hengan International Group grew its EBIT by 2.1% 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 future earnings, more than anything, that will determine Hengan International Group'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.
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, Hengan International Group recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Hengan International Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its conversion of EBIT to free cash flow was a positive. Taking all this data into account, it seems to us that Hengan International Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Hengan International Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.