The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Luoyang Glass Company Limited (HKG:1108) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Luoyang Glass's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Luoyang Glass had CN¥1.98b of debt, an increase on CN¥1.39b, over one year. However, it also had CN¥384.4m in cash, and so its net debt is CN¥1.60b.
A Look At Luoyang Glass's Liabilities
Zooming in on the latest balance sheet data, we can see that Luoyang Glass had liabilities of CN¥3.09b due within 12 months and liabilities of CN¥701.2m due beyond that. Offsetting these obligations, it had cash of CN¥384.4m as well as receivables valued at CN¥1.06b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.34b.
While this might seem like a lot, it is not so bad since Luoyang Glass has a market capitalization of CN¥4.36b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). 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).
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Luoyang Glass like a one-two punch to the gut. The debt burden here is substantial. The good news is that Luoyang Glass grew its EBIT a smooth 32% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Luoyang Glass's earnings that will influence how the balance sheet holds up in the future. 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, Luoyang Glass 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.
To be frank both Luoyang Glass's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Luoyang Glass's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Over time, share prices tend to follow earnings per share, so if you're interested in Luoyang Glass, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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