China Shengmu Organic Milk (HKG:1432) Has A Pretty Healthy 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.' 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. We note that China Shengmu Organic Milk Limited (HKG:1432) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Shengmu Organic Milk

How Much Debt Does China Shengmu Organic Milk Carry?

You can click the graphic below for the historical numbers, but it shows that China Shengmu Organic Milk had CN¥1.33b of debt in December 2020, down from CN¥2.18b, one year before. However, because it has a cash reserve of CN¥367.2m, its net debt is less, at about CN¥966.8m.

How Strong Is China Shengmu Organic Milk's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Shengmu Organic Milk had liabilities of CN¥3.28b due within 12 months and liabilities of CN¥30.4m due beyond that. Offsetting these obligations, it had cash of CN¥367.2m as well as receivables valued at CN¥136.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.80b.

This deficit is considerable relative to its market capitalization of CN¥4.10b, so it does suggest shareholders should keep an eye on China Shengmu Organic Milk's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

With net debt sitting at just 0.98 times EBITDA, China Shengmu Organic Milk is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.1 times the interest expense over the last year. And we also note warmly that China Shengmu Organic Milk grew its EBIT by 14% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Shengmu Organic Milk will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Shengmu Organic Milk produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

China Shengmu Organic Milk's net debt to EBITDA was a real positive on this analysis, as was its EBIT growth rate. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think China Shengmu Organic Milk is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example, we've discovered 4 warning signs for China Shengmu Organic Milk (1 can't be ignored!) that you should be aware of before investing here.

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.

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