Shanshan Brand Management (HKG:1749) Has A Somewhat Strained Balance Sheet

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.' 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. As with many other companies Shanshan Brand Management Co., Ltd. (HKG:1749) makes use of debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the HK Luxury industry.

How Much Debt Does Shanshan Brand Management Carry?

You can click the graphic below for the historical numbers, but it shows that Shanshan Brand Management had CN¥158.3m of debt in June 2022, down from CN¥176.9m, one year before. However, it does have CN¥74.0m in cash offsetting this, leading to net debt of about CN¥84.3m.

A Look At Shanshan Brand Management's Liabilities

According to the last reported balance sheet, Shanshan Brand Management had liabilities of CN¥525.3m due within 12 months, and liabilities of CN¥23.0m due beyond 12 months. On the other hand, it had cash of CN¥74.0m and CN¥165.2m worth of receivables due within a year. So it has liabilities totalling CN¥309.1m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥46.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Even though Shanshan Brand Management's debt is only 2.0, its interest cover is really very low at 1.8. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Importantly, Shanshan Brand Management's EBIT fell a jaw-dropping 78% 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 you can't view debt in total isolation; since Shanshan Brand Management 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Shanshan Brand Management actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

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 it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Shanshan Brand Management's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 4 warning signs for Shanshan Brand Management (2 are a bit unpleasant) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.