Stock Analysis

Is China Sinostar Group (HKG:485) Using Debt In A Risky Way?

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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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies China Sinostar Group Company Limited (HKG:485) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

View our latest analysis for China Sinostar Group

What Is China Sinostar Group's Net Debt?

The image below, which you can click on for greater detail, shows that China Sinostar Group had debt of HK$32.5m at the end of September 2022, a reduction from HK$34.4m over a year. However, it does have HK$24.9m in cash offsetting this, leading to net debt of about HK$7.60m.

SEHK:485 Debt to Equity History March 17th 2023

How Strong Is China Sinostar Group's Balance Sheet?

The latest balance sheet data shows that China Sinostar Group had liabilities of HK$76.5m due within a year, and liabilities of HK$78.0k falling due after that. On the other hand, it had cash of HK$24.9m and HK$6.22m worth of receivables due within a year. So it has liabilities totalling HK$45.5m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$50.9m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Sinostar 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.

Over 12 months, China Sinostar Group made a loss at the EBIT level, and saw its revenue drop to HK$28m, which is a fall of 25%. That makes us nervous, to say the least.

Caveat Emptor

Not only did China Sinostar Group's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost a very considerable HK$27m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled HK$11m in negative free cash flow over the last twelve months. So in short it's a really risky stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with China Sinostar Group (at least 1 which is concerning) , and understanding them should be part of your investment process.

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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