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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Haidilao International Holding Ltd. (HKG:6862) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Haidilao International Holding's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Haidilao International Holding had CN¥3.40b of debt, an increase on CN¥519.8m, over one year. However, its balance sheet shows it holds CN¥4.66b in cash, so it actually has CN¥1.26b net cash.
How Healthy Is Haidilao International Holding's Balance Sheet?
The latest balance sheet data shows that Haidilao International Holding had liabilities of CN¥8.55b due within a year, and liabilities of CN¥5.57b falling due after that. Offsetting this, it had CN¥4.66b in cash and CN¥1.04b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.41b.
Since publicly traded Haidilao International Holding shares are worth a very impressive total of CN¥278.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Haidilao International Holding boasts net cash, so it's fair to say it does not have a heavy debt load!
Shareholders should be aware that Haidilao International Holding's EBIT was down 64% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Haidilao International Holding's ability to maintain a healthy balance sheet going forward. 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. While Haidilao International Holding 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. During the last three years, Haidilao International Holding burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We could understand if investors are concerned about Haidilao International Holding's liabilities, but we can be reassured by the fact it has has net cash of CN¥1.26b. Despite its cash we think that Haidilao International Holding seems to struggle to grow its EBIT, so we are wary of the 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. Take risks, for example - Haidilao International Holding has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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