Skyworth Group (HKG:751) Use Of Debt Could Be Considered Risky

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 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. We can see that Skyworth Group Limited (HKG:751) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Skyworth Group

What Is Skyworth Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Skyworth Group had CN¥15.5b of debt, an increase on CN¥11.7b, over one year. On the flip side, it has CN¥9.75b in cash leading to net debt of about CN¥5.74b.

A Look At Skyworth Group's Liabilities

According to the last reported balance sheet, Skyworth Group had liabilities of CN¥28.5b due within 12 months, and liabilities of CN¥8.19b due beyond 12 months. Offsetting these obligations, it had cash of CN¥9.75b as well as receivables valued at CN¥16.2b due within 12 months. So its liabilities total CN¥10.8b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥5.03b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Skyworth Group would probably need a major re-capitalization if its creditors were to demand repayment.

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).

Skyworth Group has a rather high debt to EBITDA ratio of 5.5 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.7 times, suggesting it can responsibly service its obligations. Importantly, Skyworth Group's EBIT fell a jaw-dropping 40% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Skyworth Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Skyworth Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Skyworth Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its interest cover is not so bad. We think the chances that Skyworth Group has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. To that end, you should learn about the 2 warning signs we've spotted with Skyworth Group (including 1 which is significant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.

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