We Think Sun Art Retail Group (HKG:6808) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Sun Art Retail Group Limited (HKG:6808) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sun Art Retail Group

What Is Sun Art Retail Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Sun Art Retail Group had CN¥1.17b of debt, an increase on none, over one year. However, it does have CN¥20.8b in cash offsetting this, leading to net cash of CN¥19.7b.

How Healthy Is Sun Art Retail Group's Balance Sheet?

The latest balance sheet data shows that Sun Art Retail Group had liabilities of CN¥35.5b due within a year, and liabilities of CN¥6.31b falling due after that. On the other hand, it had cash of CN¥20.8b and CN¥1.85b worth of receivables due within a year. So it has liabilities totalling CN¥19.2b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥12.1b 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'd watch its balance sheet closely, without a doubt. After all, Sun Art Retail Group would likely require a major re-capitalisation if it had to pay its creditors today. Sun Art Retail Group boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

The modesty of its debt load may become crucial for Sun Art Retail Group if management cannot prevent a repeat of the 21% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sun Art Retail Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Sun Art Retail Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Sun Art Retail Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Sun Art Retail Group does have more liabilities than liquid assets, it also has net cash of CN¥19.7b. And it impressed us with free cash flow of CN¥4.0b, being 338% of its EBIT. So although we see some areas for improvement, we're not too worried about Sun Art Retail Group's balance sheet. 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. For example, we've discovered 1 warning sign for Sun Art Retail Group that you should be aware of before investing here.

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.

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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.