Befar GroupLtd (SHSE:601678) Seems To Be Using A Lot 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 can see that Befar Group Co.,Ltd (SHSE:601678) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Befar GroupLtd

How Much Debt Does Befar GroupLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Befar GroupLtd had CN¥9.01b of debt, an increase on CN¥4.79b, over one year. However, it does have CN¥2.46b in cash offsetting this, leading to net debt of about CN¥6.55b.

A Look At Befar GroupLtd's Liabilities

We can see from the most recent balance sheet that Befar GroupLtd had liabilities of CN¥5.45b falling due within a year, and liabilities of CN¥5.31b due beyond that. Offsetting these obligations, it had cash of CN¥2.46b as well as receivables valued at CN¥739.6m due within 12 months. So it has liabilities totalling CN¥7.56b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥7.88b, so it does suggest shareholders should keep an eye on Befar GroupLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

With a net debt to EBITDA ratio of 6.3, it's fair to say Befar GroupLtd does have a significant amount of debt. However, its interest coverage of 4.5 is reasonably strong, which is a good sign. Shareholders should be aware that Befar GroupLtd's EBIT was down 63% last year. 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 you can't view debt in total isolation; since Befar GroupLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Befar GroupLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Befar GroupLtd'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. But at least its interest cover is not so bad. After considering the datapoints discussed, we think Befar GroupLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 3 warning signs with Befar GroupLtd (at least 1 which is a bit unpleasant) , 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.