Is China Mengniu Dairy (HKG:2319) A Risky Investment?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, China Mengniu Dairy Company Limited (HKG:2319) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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.

See our latest analysis for China Mengniu Dairy

How Much Debt Does China Mengniu Dairy Carry?

The image below, which you can click on for greater detail, shows that China Mengniu Dairy had debt of CN¥23.4b at the end of June 2021, a reduction from CN¥29.2b over a year. However, it does have CN¥14.5b in cash offsetting this, leading to net debt of about CN¥8.96b.

How Strong Is China Mengniu Dairy's Balance Sheet?

We can see from the most recent balance sheet that China Mengniu Dairy had liabilities of CN¥27.6b falling due within a year, and liabilities of CN¥19.1b due beyond that. On the other hand, it had cash of CN¥14.5b and CN¥3.89b worth of receivables due within a year. So it has liabilities totalling CN¥28.4b more than its cash and near-term receivables, combined.

Given China Mengniu Dairy has a humongous market capitalization of CN¥156.5b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

We'd say that China Mengniu Dairy's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. In addition to that, we're happy to report that China Mengniu Dairy has boosted its EBIT by 64%, thus reducing the spectre of future debt repayments. 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 China Mengniu Dairy'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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, China Mengniu Dairy recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, China Mengniu Dairy's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Taking all this data into account, it seems to us that China Mengniu Dairy takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that China Mengniu Dairy is showing 1 warning sign in our investment analysis , you should know about...

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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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.
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