Shanshan Brand Management (HKG:1749) Seems To Use Debt Quite Sensibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Shanshan Brand Management Co., Ltd. (HKG:1749) makes use of debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

Check out our latest analysis for Shanshan Brand Management

What Is Shanshan Brand Management's Debt?

The image below, which you can click on for greater detail, shows that Shanshan Brand Management had debt of CN¥120.0m at the end of June 2023, a reduction from CN¥158.3m over a year. However, because it has a cash reserve of CN¥90.2m, its net debt is less, at about CN¥29.8m.

How Strong Is Shanshan Brand Management's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanshan Brand Management had liabilities of CN¥439.6m due within 12 months and liabilities of CN¥23.9m due beyond that. Offsetting these obligations, it had cash of CN¥90.2m as well as receivables valued at CN¥217.4m due within 12 months. So its liabilities total CN¥155.9m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥58.2m 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.43 and interest cover of 4.9 times, it seems to us that Shanshan Brand Management is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Shanshan Brand Management's EBIT launched higher than Elon Musk, gaining a whopping 218% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shanshan Brand Management'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shanshan Brand Management actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Shanshan Brand Management's level of total liabilities was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Shanshan Brand Management's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanshan Brand Management (of which 2 shouldn't be ignored!) 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.