Here's Why Yantai China Pet Foods (SZSE:002891) Can Manage Its Debt Responsibly

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Yantai China Pet Foods Co., Ltd. (SZSE:002891) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Yantai China Pet Foods

What Is Yantai China Pet Foods's Net Debt?

As you can see below, Yantai China Pet Foods had CN¥1.08b 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¥385.8m in cash offsetting this, leading to net debt of about CN¥691.7m.

How Strong Is Yantai China Pet Foods' Balance Sheet?

The latest balance sheet data shows that Yantai China Pet Foods had liabilities of CN¥799.9m due within a year, and liabilities of CN¥784.3m falling due after that. Offsetting these obligations, it had cash of CN¥385.8m as well as receivables valued at CN¥617.9m due within 12 months. So its liabilities total CN¥580.6m more than the combination of its cash and short-term receivables.

Given Yantai China Pet Foods has a market capitalization of CN¥6.42b, 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Yantai China Pet Foods has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 47.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Yantai China Pet Foods grew its EBIT by 84% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Yantai China Pet Foods'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Yantai China Pet Foods burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Yantai China Pet Foods's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Yantai China Pet Foods can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Yantai China Pet Foods you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.