David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 Red Star Macalline Group Corporation Ltd. (HKG:1528) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company’s use of debt, we first look at cash and debt together.
What Is Red Star Macalline Group’s Net Debt?
As you can see below, at the end of September 2019, Red Star Macalline Group had CN¥44.3b of debt, up from CN¥32.4k a year ago. Click the image for more detail. However, it also had CN¥8.47b in cash, and so its net debt is CN¥35.9b.
How Healthy Is Red Star Macalline Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Red Star Macalline Group had liabilities of CN¥24.8b due within 12 months and liabilities of CN¥49.2b due beyond that. On the other hand, it had cash of CN¥8.47b and CN¥5.34b worth of receivables due within a year. So its liabilities total CN¥60.2b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥38.3b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Red Star Macalline Group would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Red Star Macalline Group has a rather high debt to EBITDA ratio of 5.7 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that Red Star Macalline Group grew its EBIT at 19% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Red Star Macalline Group’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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. Over the last three years, Red Star Macalline Group recorded negative free cash flow, in total. 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, Red Star Macalline Group’s net debt to EBITDA 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. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Red Star Macalline Group’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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. To that end, you should learn about the 4 warning signs we’ve spotted with Red Star Macalline Group (including 1 which is is potentially serious) .
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.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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