We Think Green Future Food Hydrocolloid Marine Science (HKG:1084) Is Taking Some Risk With Its Debt

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.' 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 note that Green Future Food Hydrocolloid Marine Science Company Limited (HKG:1084) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Green Future Food Hydrocolloid Marine Science

What Is Green Future Food Hydrocolloid Marine Science's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Green Future Food Hydrocolloid Marine Science had debt of HK$423.9m, up from HK$394.9m in one year. On the flip side, it has HK$163.7m in cash leading to net debt of about HK$260.2m.

How Strong Is Green Future Food Hydrocolloid Marine Science's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Green Future Food Hydrocolloid Marine Science had liabilities of HK$484.0m due within 12 months and liabilities of HK$94.2m due beyond that. On the other hand, it had cash of HK$163.7m and HK$184.2m worth of receivables due within a year. So its liabilities total HK$230.3m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Green Future Food Hydrocolloid Marine Science is worth HK$824.6m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

While Green Future Food Hydrocolloid Marine Science's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.6 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. On the other hand, Green Future Food Hydrocolloid Marine Science saw its EBIT drop by 9.6% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Green Future Food Hydrocolloid Marine Science will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Green Future Food Hydrocolloid Marine Science 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

We'd go so far as to say Green Future Food Hydrocolloid Marine Science's conversion of EBIT to free cash flow was disappointing. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Green Future Food Hydrocolloid Marine Science stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Take risks, for example - Green Future Food Hydrocolloid Marine Science has 3 warning signs (and 1 which is potentially serious) we think you should know about.

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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