Shenzhen Best of Best HoldingsLtd (SZSE:001298) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Shenzhen Best of Best Holdings Co.,Ltd. (SZSE:001298) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shenzhen Best of Best HoldingsLtd

How Much Debt Does Shenzhen Best of Best HoldingsLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Shenzhen Best of Best HoldingsLtd had CN¥957.7m of debt, an increase on CN¥803.7m, over one year. On the flip side, it has CN¥365.1m in cash leading to net debt of about CN¥592.6m.

How Healthy Is Shenzhen Best of Best HoldingsLtd's Balance Sheet?

The latest balance sheet data shows that Shenzhen Best of Best HoldingsLtd had liabilities of CN¥1.28b due within a year, and liabilities of CN¥6.08m falling due after that. On the other hand, it had cash of CN¥365.1m and CN¥1.68b worth of receivables due within a year. So it can boast CN¥765.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Shenzhen Best of Best HoldingsLtd could probably pay off its debt with ease, as its balance sheet is far from stretched.

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.

Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 9.0 hit our confidence in Shenzhen Best of Best HoldingsLtd like a one-two punch to the gut. The debt burden here is substantial. Worse, Shenzhen Best of Best HoldingsLtd's EBIT was down 41% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Shenzhen Best of Best HoldingsLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shenzhen Best of Best HoldingsLtd 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 Shenzhen Best of Best HoldingsLtd'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 it's pretty decent at staying on top of its total liabilities; that's encouraging. Overall, we think it's fair to say that Shenzhen Best of Best HoldingsLtd has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Shenzhen Best of Best HoldingsLtd (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.