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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Shanshan Brand Management Co., Ltd. (HKG:1749) 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Shanshan Brand Management's Net Debt?
As you can see below, Shanshan Brand Management had CN¥260.0m of debt at December 2018, down from CN¥285.0m a year prior. However, it does have CN¥145.4m in cash offsetting this, leading to net debt of about CN¥114.6m.
How Strong Is Shanshan Brand Management's Balance Sheet?
According to the balance sheet data, Shanshan Brand Management had liabilities of CN¥745.3m due within 12 months, but no longer term liabilities. On the other hand, it had cash of CN¥145.4m and CN¥217.9m worth of receivables due within a year. So its liabilities total CN¥381.9m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥156.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Shanshan Brand Management would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Shanshan Brand Management's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.8 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The bad news is that Shanshan Brand Management saw its EBIT decline by 14% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanshan Brand Management will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Shanshan Brand Management actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Shanshan Brand Management's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. After considering the datapoints discussed, we think Shanshan Brand Management has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given Shanshan Brand Management 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.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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