DaChan Food (Asia) (HKG:3999) Has A Pretty Healthy Balance Sheet

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.' 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. As with many other companies DaChan Food (Asia) Limited (HKG:3999) makes use of debt. But the more important question is: how much risk is that debt creating?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 DaChan Food (Asia)

What Is DaChan Food (Asia)'s Debt?

The image below, which you can click on for greater detail, shows that DaChan Food (Asia) had debt of CN¥900.1m at the end of September 2020, a reduction from CN¥1.04b over a year. However, it does have CN¥612.4m in cash offsetting this, leading to net debt of about CN¥287.7m.

How Strong Is DaChan Food (Asia)'s Balance Sheet?

According to the last reported balance sheet, DaChan Food (Asia) had liabilities of CN¥1.49b due within 12 months, and liabilities of CN¥593.9m due beyond 12 months. Offsetting these obligations, it had cash of CN¥612.4m as well as receivables valued at CN¥799.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥675.7m.

This deficit is considerable relative to its market capitalization of CN¥711.2m, so it does suggest shareholders should keep an eye on DaChan Food (Asia)'s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

DaChan Food (Asia)'s net debt is only 0.48 times its EBITDA. And its EBIT covers its interest expense a whopping 19.2 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that DaChan Food (Asia) grew its EBIT by 141% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is DaChan Food (Asia)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, DaChan Food (Asia) reported free cash flow worth 20% 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

DaChan Food (Asia)'s interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about DaChan Food (Asia)'s use of debt. 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. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with DaChan Food (Asia) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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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