The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Ausnutria Dairy Corporation Ltd (HKG:1717) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ausnutria Dairy's Net Debt?
As you can see below, Ausnutria Dairy had CN¥775.1m of debt at December 2020, down from CN¥922.8m a year prior. However, its balance sheet shows it holds CN¥1.86b in cash, so it actually has CN¥1.08b net cash.
How Strong Is Ausnutria Dairy's Balance Sheet?
According to the last reported balance sheet, Ausnutria Dairy had liabilities of CN¥3.39b due within 12 months, and liabilities of CN¥703.3m due beyond 12 months. Offsetting this, it had CN¥1.86b in cash and CN¥456.4m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.78b more than its cash and near-term receivables, combined.
Since publicly traded Ausnutria Dairy shares are worth a total of CN¥15.8b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Ausnutria Dairy boasts net cash, so it's fair to say it does not have a heavy debt load!
Fortunately, Ausnutria Dairy grew its EBIT by 3.7% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ausnutria Dairy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Ausnutria Dairy has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Ausnutria Dairy produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Ausnutria Dairy's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥1.08b. So we are not troubled with Ausnutria Dairy's debt use. 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. To that end, you should be aware of the 2 warning signs we've spotted with Ausnutria Dairy .
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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