Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Luzhou Xinglu Water (Group) Co., Ltd. (HKG:2281) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Luzhou Xinglu Water (Group)'s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Luzhou Xinglu Water (Group) had CN¥844.4m of debt, an increase on CN¥602.8m, over one year. However, it does have CN¥547.7m in cash offsetting this, leading to net debt of about CN¥296.8m.
A Look At Luzhou Xinglu Water (Group)'s Liabilities
The latest balance sheet data shows that Luzhou Xinglu Water (Group) had liabilities of CN¥988.1m due within a year, and liabilities of CN¥866.8m falling due after that. Offsetting this, it had CN¥547.7m in cash and CN¥205.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.10b.
When you consider that this deficiency exceeds the company's CN¥881.0m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Luzhou Xinglu Water (Group) has a low debt to EBITDA ratio of only 1.1. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. The good news is that Luzhou Xinglu Water (Group) has increased its EBIT by 6.8% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Luzhou Xinglu Water (Group) will need earnings to service that debt. 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. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Luzhou Xinglu Water (Group) burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We'd go so far as to say Luzhou Xinglu Water (Group)'s conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Luzhou Xinglu Water (Group) is in the Water Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Luzhou Xinglu Water (Group) stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given Luzhou Xinglu Water (Group) has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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