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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that China Feihe Limited (HKG:6186) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for China Feihe
What Is China Feihe's Net Debt?
You can click the graphic below for the historical numbers, but it shows that China Feihe had CN¥898.2m of debt in June 2021, down from CN¥1.24b, one year before. However, its balance sheet shows it holds CN¥16.2b in cash, so it actually has CN¥15.4b net cash.
A Look At China Feihe's Liabilities
According to the last reported balance sheet, China Feihe had liabilities of CN¥5.79b due within 12 months, and liabilities of CN¥2.20b due beyond 12 months. Offsetting this, it had CN¥16.2b in cash and CN¥351.0m in receivables that were due within 12 months. So it can boast CN¥8.61b more liquid assets than total liabilities.
This surplus suggests that China Feihe has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that China Feihe has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, China Feihe grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. 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 Feihe'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Feihe may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, China Feihe recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that China Feihe has net cash of CN¥15.4b, as well as more liquid assets than liabilities. And we liked the look of last year's 36% year-on-year EBIT growth. So we don't think China Feihe's use of debt is 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. To that end, you should learn about the 3 warning signs we've spotted with China Feihe (including 1 which doesn't sit too well with us) .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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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About SEHK:6186
China Feihe
An investment holding company, produces and sells infant milk formula products in Mainland China, Canada, and the United States.
Flawless balance sheet and undervalued.