Does Evergreen Products Group (HKG:1962) Have A Healthy Balance Sheet?

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. We can see that Evergreen Products Group Limited (HKG:1962) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Evergreen Products Group

How Much Debt Does Evergreen Products Group Carry?

The chart below, which you can click on for greater detail, shows that Evergreen Products Group had HK$781.7m in debt in December 2020; about the same as the year before. On the flip side, it has HK$70.2m in cash leading to net debt of about HK$711.4m.

A Look At Evergreen Products Group's Liabilities

The latest balance sheet data shows that Evergreen Products Group had liabilities of HK$859.6m due within a year, and liabilities of HK$24.6m falling due after that. On the other hand, it had cash of HK$70.2m and HK$247.1m worth of receivables due within a year. So it has liabilities totalling HK$566.9m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$878.2m. 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).

Evergreen Products Group shareholders face the double whammy of a high net debt to EBITDA ratio (13.8), and fairly weak interest coverage, since EBIT is just 0.63 times the interest expense. The debt burden here is substantial. Worse, Evergreen Products Group's EBIT was down 87% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Evergreen Products Group can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Evergreen Products Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Evergreen Products Group's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Evergreen Products Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Evergreen Products Group is showing 4 warning signs in our investment analysis , and 2 of those are potentially serious...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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