China Shengmu Organic Milk (HKG:1432) Has A Somewhat Strained Balance Sheet

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.' 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. Importantly, China Shengmu Organic Milk Limited (HKG:1432) does carry debt. But the real question is whether this debt is making the company risky.

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that 1432 is potentially undervalued!

What Is China Shengmu Organic Milk's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 China Shengmu Organic Milk had debt of CN¥1.95b, up from CN¥1.82b in one year. However, because it has a cash reserve of CN¥802.9m, its net debt is less, at about CN¥1.15b.

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

The latest balance sheet data shows that China Shengmu Organic Milk had liabilities of CN¥2.69b due within a year, and liabilities of CN¥310.5m falling due after that. Offsetting these obligations, it had cash of CN¥802.9m as well as receivables valued at CN¥272.1m due within 12 months. So it has liabilities totalling CN¥1.93b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥2.67b, so it does suggest shareholders should keep an eye on China Shengmu Organic Milk's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

China Shengmu Organic Milk has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 23.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, China Shengmu Organic Milk's EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Shengmu Organic Milk reported free cash flow worth 13% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

China Shengmu Organic Milk's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that China Shengmu Organic Milk is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 1 warning sign for China Shengmu Organic Milk that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.