These 4 Measures Indicate That FriendLtd (SHSE:605050) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Friend Co.,Ltd. (SHSE:605050) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for FriendLtd

How Much Debt Does FriendLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2024 FriendLtd had debt of CN¥1.52b, up from CN¥231.2m in one year. However, it also had CN¥1.12b in cash, and so its net debt is CN¥405.8m.

How Strong Is FriendLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that FriendLtd had liabilities of CN¥4.12b due within 12 months and liabilities of CN¥30.4m due beyond that. Offsetting this, it had CN¥1.12b in cash and CN¥2.77b in receivables that were due within 12 months. So its liabilities total CN¥263.0m more than the combination of its cash and short-term receivables.

Of course, FriendLtd has a market capitalization of CN¥5.15b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

FriendLtd has a low net debt to EBITDA ratio of only 0.81. And its EBIT covers its interest expense a whopping 428 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that FriendLtd has seen its EBIT plunge 11% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is FriendLtd's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, FriendLtd 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

Neither FriendLtd's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We think that FriendLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example FriendLtd has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.