We Think Shanshan Brand Management (HKG:1749) Is Taking Some Risk With Its 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. As with many other companies Shanshan Brand Management Co., Ltd. (HKG:1749) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shanshan Brand Management

What Is Shanshan Brand Management's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shanshan Brand Management had CN¥172.9m of debt in December 2021, down from CN¥202.2m, one year before. On the flip side, it has CN¥84.3m in cash leading to net debt of about CN¥88.6m.

How Healthy Is Shanshan Brand Management's Balance Sheet?

The latest balance sheet data shows that Shanshan Brand Management had liabilities of CN¥592.2m due within a year, and liabilities of CN¥21.7m falling due after that. Offsetting this, it had CN¥84.3m in cash and CN¥176.5m in receivables that were due within 12 months. So its liabilities total CN¥353.1m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥85.8m 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.4 and interest cover of 4.1 times, it seems to us that Shanshan Brand Management is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Shanshan Brand Management improved its EBIT from a last year's loss to a positive CN¥33m. 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 Shanshan Brand Management 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Shanshan Brand Management produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say Shanshan Brand Management's level of total liabilities was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Shanshan Brand Management's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 4 warning signs for Shanshan Brand Management (of which 1 is potentially serious!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.