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 Nanjing Sample Technology Company Limited (HKG:1708) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Nanjing Sample Technology's Debt?
As you can see below, at the end of June 2019, Nanjing Sample Technology had CN¥1.25b of debt, up from CN¥1.02b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥613.6m, its net debt is less, at about CN¥639.8m.
A Look At Nanjing Sample Technology's Liabilities
Zooming in on the latest balance sheet data, we can see that Nanjing Sample Technology had liabilities of CN¥2.28b due within 12 months and liabilities of CN¥462.6m due beyond that. Offsetting this, it had CN¥613.6m in cash and CN¥2.51b in receivables that were due within 12 months. So it can boast CN¥378.0m more liquid assets than total liabilities.
This surplus suggests that Nanjing Sample Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty.
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).
Nanjing Sample Technology has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.7 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Nanjing Sample Technology saw its EBIT slide 7.0% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Nanjing Sample Technology 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Nanjing Sample Technology 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.
Nanjing Sample Technology's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to handle its total liabilities isn't too shabby at all. Taking the abovementioned factors together we do think Nanjing Sample Technology's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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