SDIC Zhonglu Fruit JuiceLtd (SHSE:600962) Takes On Some Risk With Its Use Of 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.' 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. We note that SDIC Zhonglu Fruit Juice Co.,Ltd. (SHSE:600962) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for SDIC Zhonglu Fruit JuiceLtd

What Is SDIC Zhonglu Fruit JuiceLtd's Debt?

As you can see below, SDIC Zhonglu Fruit JuiceLtd had CN¥902.8m of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥165.3m in cash offsetting this, leading to net debt of about CN¥737.5m.

How Strong Is SDIC Zhonglu Fruit JuiceLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that SDIC Zhonglu Fruit JuiceLtd had liabilities of CN¥1.01b due within 12 months and liabilities of CN¥30.3m due beyond that. Offsetting these obligations, it had cash of CN¥165.3m as well as receivables valued at CN¥287.9m due within 12 months. So its liabilities total CN¥584.4m more than the combination of its cash and short-term receivables.

Given SDIC Zhonglu Fruit JuiceLtd has a market capitalization of CN¥3.53b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 6.1 hit our confidence in SDIC Zhonglu Fruit JuiceLtd like a one-two punch to the gut. The debt burden here is substantial. Worse, SDIC Zhonglu Fruit JuiceLtd's EBIT was down 46% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SDIC Zhonglu Fruit JuiceLtd's earnings that will influence how the balance sheet holds up in the future. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last two years, SDIC Zhonglu Fruit JuiceLtd 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.

Our View

To be frank both SDIC Zhonglu Fruit JuiceLtd's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider SDIC Zhonglu Fruit JuiceLtd to be really rather risky, as a result of its balance sheet health. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for SDIC Zhonglu Fruit JuiceLtd (of which 2 can't be ignored!) you should know about.

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.