Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
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 Risun Group Limited (HKG:1907) does use debt in its business. 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. 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 sure 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.
How Much Debt Does China Risun Group Carry?
You can click the graphic below for the historical numbers, but it shows that China Risun Group had CN¥8.91b of debt in December 2018, down from CN¥9.84b, one year before However, it also had CN¥759.3m in cash, and so its net debt is CN¥8.16b.
How Healthy Is China Risun Group’s Balance Sheet?
The latest balance sheet data shows that China Risun Group had liabilities of CN¥16.4b due within a year, and liabilities of CN¥1.48b falling due after that. Offsetting this, it had CN¥759.3m in cash and CN¥3.85b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥13.3b.
When you consider that this deficiency exceeds the company’s CN¥10.2b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Either way, since China Risun Group does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
China Risun Group has a debt to EBITDA ratio of 2.63, which betrays significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 10.7 times its interest expense, implying the company isn’t really paying full freight on that debt. Even if not sustainable, that is a good sign. Notably, China Risun Group’s EBIT launched higher than Elon Musk, gaining a whopping 146% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since China Risun Group will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, China Risun Group produced sturdy free cash flow equating to 65% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Both China Risun Group’s ability to to grow its EBIT and its interest cover gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about China Risun Group’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. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check China Risun Group’s dividend history, without delay!
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.