We Think Jiangsu Lihua Animal Husbandry (SZSE:300761) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Jiangsu Lihua Animal Husbandry Co., Ltd. (SZSE:300761) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Jiangsu Lihua Animal Husbandry

What Is Jiangsu Lihua Animal Husbandry's Net Debt?

As you can see below, at the end of March 2024, Jiangsu Lihua Animal Husbandry had CN¥2.68b of debt, up from CN¥2.55b a year ago. Click the image for more detail. However, it also had CN¥1.16b in cash, and so its net debt is CN¥1.52b.

How Healthy Is Jiangsu Lihua Animal Husbandry's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu Lihua Animal Husbandry had liabilities of CN¥5.39b falling due within a year, and liabilities of CN¥789.6m due beyond that. On the other hand, it had cash of CN¥1.16b and CN¥255.4m worth of receivables due within a year. So its liabilities total CN¥4.76b more than the combination of its cash and short-term receivables.

Jiangsu Lihua Animal Husbandry has a market capitalization of CN¥20.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Even though Jiangsu Lihua Animal Husbandry's debt is only 1.9, its interest cover is really very low at 1.3. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Importantly, Jiangsu Lihua Animal Husbandry's EBIT fell a jaw-dropping 84% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Jiangsu Lihua Animal Husbandry's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Jiangsu Lihua Animal Husbandry saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Jiangsu Lihua Animal Husbandry's conversion of EBIT to free cash flow 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 Jiangsu Lihua Animal Husbandry to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 2 warning signs for Jiangsu Lihua Animal Husbandry that you should be aware of before investing here.

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.

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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.