Here's Why DaChan Food (Asia) (HKG:3999) Has A Meaningful Debt Burden

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 DaChan Food (Asia) Limited (HKG:3999) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for DaChan Food (Asia)

What Is DaChan Food (Asia)'s Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 DaChan Food (Asia) had debt of CN¥507.2m, up from CN¥389.8m in one year. However, it does have CN¥480.0m in cash offsetting this, leading to net debt of about CN¥27.3m.

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

We can see from the most recent balance sheet that DaChan Food (Asia) had liabilities of CN¥1.07b falling due within a year, and liabilities of CN¥380.4m due beyond that. Offsetting this, it had CN¥480.0m in cash and CN¥612.4m in receivables that were due within 12 months. So it has liabilities totalling CN¥360.8m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥598.3m, 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). 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).

DaChan Food (Asia)'s net debt is only 0.11 times its EBITDA. And its EBIT easily covers its interest expense, being 212 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. DaChan Food (Asia)'s EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, DaChan Food (Asia) reported free cash flow worth 5.7% 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

We feel some trepidation about DaChan Food (Asia)'s difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that DaChan Food (Asia)'s debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example - DaChan Food (Asia) has 1 warning sign we think you should be aware of.

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.