These 4 Measures Indicate That Narnia (Hong Kong) Group (HKG:8607) Is Using Debt In A Risky Way

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. Importantly, Narnia (Hong Kong) Group Company Limited (HKG:8607) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Narnia (Hong Kong) Group

How Much Debt Does Narnia (Hong Kong) Group Carry?

You can click the graphic below for the historical numbers, but it shows that Narnia (Hong Kong) Group had CN¥92.6m of debt in June 2021, down from CN¥114.0m, one year before. However, because it has a cash reserve of CN¥6.33m, its net debt is less, at about CN¥86.3m.

How Strong Is Narnia (Hong Kong) Group's Balance Sheet?

The latest balance sheet data shows that Narnia (Hong Kong) Group had liabilities of CN¥134.5m due within a year, and liabilities of CN¥26.5m falling due after that. Offsetting these obligations, it had cash of CN¥6.33m as well as receivables valued at CN¥42.1m due within 12 months. So it has liabilities totalling CN¥112.7m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥111.4m, we think shareholders really should watch Narnia (Hong Kong) Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

While we wouldn't worry about Narnia (Hong Kong) Group's net debt to EBITDA ratio of 4.4, we think its super-low interest cover of 2.4 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Narnia (Hong Kong) Group saw its EBIT tank 49% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Narnia (Hong Kong) Group 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Narnia (Hong Kong) Group created free cash flow amounting to 2.7% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Narnia (Hong Kong) Group's EBIT growth rate was disappointing. And even its net debt to EBITDA fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Narnia (Hong Kong) Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 5 warning signs with Narnia (Hong Kong) Group (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

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.

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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