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. Importantly, Shanshan Brand Management Co., Ltd. (HKG:1749) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Shanshan Brand Management Carry?
As you can see below, at the end of June 2019, Shanshan Brand Management had CN¥285.0m of debt, up from CN¥265.0m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥102.1m, its net debt is less, at about CN¥182.9m.
A Look At Shanshan Brand Management’s Liabilities
We can see from the most recent balance sheet that Shanshan Brand Management had liabilities of CN¥786.8m falling due within a year, and liabilities of CN¥22.8m due beyond that. On the other hand, it had cash of CN¥102.1m and CN¥259.5m worth of receivables due within a year. So it has liabilities totalling CN¥448.0m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥118.1m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt After all, Shanshan Brand Management would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Shanshan Brand Management has net debt worth 2.1 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.2 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Importantly, Shanshan Brand Management’s EBIT fell a jaw-dropping 43% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There’s no doubt that we learn most about debt from the balance sheet. But it is Shanshan Brand Management’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.
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. During the last three years, Shanshan Brand Management burned a lot of cash. 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.
To be frank both Shanshan Brand Management’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its net debt to EBITDA is not so bad. Considering all the factors previously mentioned, we think that Shanshan Brand Management really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. Given Shanshan Brand Management has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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