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. 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, Zhengye International Holdings Company Limited (HKG:3363) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Zhengye International Holdings Carry?
As you can see below, at the end of June 2019, Zhengye International Holdings had CN¥994.4m of debt, up from CN¥928.7m a year ago. Click the image for more detail. On the flip side, it has CN¥232.3m in cash leading to net debt of about CN¥762.1m.
How Healthy Is Zhengye International Holdings's Balance Sheet?
According to the last reported balance sheet, Zhengye International Holdings had liabilities of CN¥1.27b due within 12 months, and liabilities of CN¥84.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥232.3m as well as receivables valued at CN¥840.2m due within 12 months. So it has liabilities totalling CN¥281.1m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CN¥411.2m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Zhengye International Holdings's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 5.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, Zhengye International Holdings's EBIT actually dropped 8.0% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhengye International Holdings'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zhengye International Holdings recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Zhengye International Holdings's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Zhengye International Holdings is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Zhengye International Holdings's dividend history, without delay!
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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