Is Bright Dairy & FoodLtd (SHSE:600597) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Bright Dairy & Food Co.,Ltd (SHSE:600597) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Bright Dairy & FoodLtd

What Is Bright Dairy & FoodLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Bright Dairy & FoodLtd had debt of CN¥2.93b, up from CN¥2.74b in one year. On the flip side, it has CN¥2.69b in cash leading to net debt of about CN¥240.0m.

How Healthy Is Bright Dairy & FoodLtd's Balance Sheet?

The latest balance sheet data shows that Bright Dairy & FoodLtd had liabilities of CN¥9.16b due within a year, and liabilities of CN¥2.54b falling due after that. Offsetting these obligations, it had cash of CN¥2.69b as well as receivables valued at CN¥2.25b due within 12 months. So its liabilities total CN¥6.76b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥10.8b, so it does suggest shareholders should keep an eye on Bright Dairy & FoodLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Looking at its net debt to EBITDA of 0.13 and interest cover of 4.4 times, it seems to us that Bright Dairy & FoodLtd is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. One way Bright Dairy & FoodLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Bright Dairy & FoodLtd'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.

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, Bright Dairy & FoodLtd reported free cash flow worth 5.9% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither Bright Dairy & FoodLtd's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able handle its debt, based on its EBITDA, with ease. We think that Bright Dairy & FoodLtd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Bright Dairy & FoodLtd is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.