China Modern Dairy Holdings (HKG:1117) Has A Somewhat Strained Balance Sheet

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 note that China Modern Dairy Holdings Ltd. (HKG:1117) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Modern Dairy Holdings

What Is China Modern Dairy Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 China Modern Dairy Holdings had CN¥13.8b of debt, an increase on CN¥12.3b, over one year. However, it does have CN¥3.65b in cash offsetting this, leading to net debt of about CN¥10.2b.

A Look At China Modern Dairy Holdings' Liabilities

We can see from the most recent balance sheet that China Modern Dairy Holdings had liabilities of CN¥7.11b falling due within a year, and liabilities of CN¥13.1b due beyond that. Offsetting this, it had CN¥3.65b in cash and CN¥1.54b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥15.0b.

This deficit casts a shadow over the CN¥6.64b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, China Modern Dairy Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

China Modern Dairy Holdings's debt is 4.2 times its EBITDA, and its EBIT cover its interest expense 4.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw China Modern Dairy Holdings grow its EBIT by 3.0% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 China Modern Dairy Holdings'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Modern Dairy Holdings saw substantial negative free cash flow, in total. 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.

Our View

To be frank both China Modern Dairy Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think China Modern Dairy Holdings 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for China Modern Dairy Holdings you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.