Is San Miguel Brewery Hong Kong (HKG:236) Using Too Much Debt?

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 San Miguel Brewery Hong Kong Limited (HKG:236) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.

View 2 warning signs we detected for San Miguel Brewery Hong Kong

What Is San Miguel Brewery Hong Kong’s Net Debt?

The image below, which you can click on for greater detail, shows that at June 2019 San Miguel Brewery Hong Kong had debt of HK$102.6m, up from HK$142 in one year. However, its balance sheet shows it holds HK$121.2m in cash, so it actually has HK$18.6m net cash.

SEHK:236 Historical Debt, January 10th 2020
SEHK:236 Historical Debt, January 10th 2020

A Look At San Miguel Brewery Hong Kong’s Liabilities

The latest balance sheet data shows that San Miguel Brewery Hong Kong had liabilities of HK$127.9m due within a year, and liabilities of HK$100.7m falling due after that. Offsetting these obligations, it had cash of HK$121.2m as well as receivables valued at HK$64.8m due within 12 months. So it has liabilities totalling HK$42.6m more than its cash and near-term receivables, combined.

Given San Miguel Brewery Hong Kong has a market capitalization of HK$366.1m, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, San Miguel Brewery Hong Kong also has more cash than debt, so we’re pretty confident it can manage its debt safely.

Shareholders should be aware that San Miguel Brewery Hong Kong’s EBIT was down 46% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 2 warning signs for San Miguel Brewery Hong Kong (of which 1 is major) which any shareholder or potential investor should be aware of.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While San Miguel Brewery Hong Kong has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, San Miguel Brewery Hong Kong actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.

Summing up

Although San Miguel Brewery Hong Kong’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$18.6m. The cherry on top was that in converted 176% of that EBIT to free cash flow, bringing in HK$18m. So we are not troubled with San Miguel Brewery Hong Kong’s debt use. Even though San Miguel Brewery Hong Kong lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.