These 4 Measures Indicate That COFCO Joycome Foods (HKG:1610) Is Using Debt Reasonably Well

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 COFCO Joycome Foods Limited (HKG:1610) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for COFCO Joycome Foods

How Much Debt Does COFCO Joycome Foods Carry?

As you can see below, at the end of December 2020, COFCO Joycome Foods had CN¥8.49b of debt, up from CN¥7.89b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥431.3m, its net debt is less, at about CN¥8.06b.

How Healthy Is COFCO Joycome Foods' Balance Sheet?

We can see from the most recent balance sheet that COFCO Joycome Foods had liabilities of CN¥10.1b falling due within a year, and liabilities of CN¥847.0m due beyond that. On the other hand, it had cash of CN¥431.3m and CN¥1.15b worth of receivables due within a year. So its liabilities total CN¥9.40b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥11.8b, 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.

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). 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).

COFCO Joycome Foods's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 57.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that COFCO Joycome Foods grew its EBIT by 419% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. 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 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last two years, COFCO Joycome Foods actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

COFCO Joycome Foods's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about COFCO Joycome Foods's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for COFCO Joycome Foods (of which 1 can't be ignored!) 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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