COFCO Joycome Foods (HKG:1610) Seems To Use Debt Quite Sensibly

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 COFCO Joycome Foods Limited (HKG:1610) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for COFCO Joycome Foods

What Is COFCO Joycome Foods's Debt?

You can click the graphic below for the historical numbers, but it shows that COFCO Joycome Foods had CN¥4.73b of debt in June 2023, down from CN¥8.51b, one year before. However, because it has a cash reserve of CN¥524.2m, its net debt is less, at about CN¥4.20b.

A Look At COFCO Joycome Foods' Liabilities

Zooming in on the latest balance sheet data, we can see that COFCO Joycome Foods had liabilities of CN¥6.60b due within 12 months and liabilities of CN¥806.2m due beyond that. Offsetting these obligations, it had cash of CN¥524.2m as well as receivables valued at CN¥1.07b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.82b.

This deficit is considerable relative to its market capitalization of CN¥7.24b, so it does suggest shareholders should keep an eye on COFCO Joycome Foods' 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

COFCO Joycome Foods's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its commanding EBIT of 18.7 times its interest expense, implies the debt load is as light as a peacock feather. Better yet, COFCO Joycome Foods grew its EBIT by 9,422% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 COFCO Joycome Foods'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, COFCO Joycome Foods recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that COFCO Joycome Foods's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that COFCO Joycome Foods can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for COFCO Joycome Foods you should know about.

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.