Is Sanquan Food (SZSE:002216) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Sanquan Food Co., Ltd. (SZSE:002216) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sanquan Food

What Is Sanquan Food's Net Debt?

As you can see below, at the end of September 2023, Sanquan Food had CN¥250.1m of debt, up from CN¥150.1m a year ago. Click the image for more detail. However, it does have CN¥1.54b in cash offsetting this, leading to net cash of CN¥1.29b.

How Healthy Is Sanquan Food's Balance Sheet?

According to the last reported balance sheet, Sanquan Food had liabilities of CN¥2.56b due within 12 months, and liabilities of CN¥256.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.54b as well as receivables valued at CN¥589.0m due within 12 months. So it has liabilities totalling CN¥679.3m more than its cash and near-term receivables, combined.

Given Sanquan Food has a market capitalization of CN¥10.8b, 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, Sanquan Food also has more cash than debt, so we're pretty confident it can manage its debt safely.

Sanquan Food's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sanquan Food can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Sanquan Food 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. During the last three years, Sanquan Food produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Sanquan Food has CN¥1.29b in net cash. The cherry on top was that in converted 69% of that EBIT to free cash flow, bringing in CN¥268m. So we don't think Sanquan Food's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Sanquan Food (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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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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.