Is Zall Smart Commerce Group (HKG:2098) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Zall Smart Commerce Group Ltd. (HKG:2098) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zall Smart Commerce Group

What Is Zall Smart Commerce Group's Net Debt?

As you can see below, at the end of December 2020, Zall Smart Commerce Group had CN¥20.7b of debt, up from CN¥18.5b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥5.04b, its net debt is less, at about CN¥15.6b.

A Look At Zall Smart Commerce Group's Liabilities

We can see from the most recent balance sheet that Zall Smart Commerce Group had liabilities of CN¥33.3b falling due within a year, and liabilities of CN¥10.5b due beyond that. Offsetting these obligations, it had cash of CN¥5.04b as well as receivables valued at CN¥9.71b due within 12 months. So it has liabilities totalling CN¥29.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥5.81b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Zall Smart Commerce Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Zall Smart Commerce Group shareholders face the double whammy of a high net debt to EBITDA ratio (101), and fairly weak interest coverage, since EBIT is just 0.12 times the interest expense. The debt burden here is substantial. Worse, Zall Smart Commerce Group's EBIT was down 62% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zall Smart Commerce Group's earnings that will influence how the balance sheet holds up in the future. 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Zall Smart Commerce Group 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

On the face of it, Zall Smart Commerce Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. It looks to us like Zall Smart Commerce Group carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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 Zall Smart Commerce Group (at least 2 which are a bit unpleasant) , and understanding them should be part of your investment process.

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. 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.
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