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.' 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 Zhongsheng Group Holdings Limited (HKG:881) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Zhongsheng Group Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that Zhongsheng Group Holdings had CN¥24.9b of debt in June 2019, down from CN¥26.3b, one year before. On the flip side, it has CN¥7.90b in cash leading to net debt of about CN¥17.0b.
A Look At Zhongsheng Group Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that Zhongsheng Group Holdings had liabilities of CN¥26.6b due within 12 months and liabilities of CN¥13.3b due beyond that. Offsetting these obligations, it had cash of CN¥7.90b as well as receivables valued at CN¥1.70b due within 12 months. So it has liabilities totalling CN¥30.3b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CN¥50.2b, so it does suggest shareholders should keep an eye on Zhongsheng Group Holdings's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Zhongsheng Group Holdings's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 5.5 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Zhongsheng Group Holdings grew its EBIT by 2.9% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Zhongsheng Group Holdings 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Zhongsheng Group Holdings recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Both Zhongsheng Group Holdings's level of total liabilities and its net debt to EBITDA were discouraging. At least its EBIT growth rate gives us reason to be optimistic. Looking at all the angles mentioned above, it does seem to us that Zhongsheng Group Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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