Sinofert Holdings (HKG:297) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Sinofert Holdings Limited (HKG:297) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sinofert Holdings

What Is Sinofert Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Sinofert Holdings had CN¥1.71b of debt in December 2020, down from CN¥2.40b, one year before. However, it does have CN¥767.2m in cash offsetting this, leading to net debt of about CN¥947.1m.

How Strong Is Sinofert Holdings' Balance Sheet?

According to the last reported balance sheet, Sinofert Holdings had liabilities of CN¥8.54b due within 12 months, and liabilities of CN¥405.7m due beyond 12 months. Offsetting these obligations, it had cash of CN¥767.2m as well as receivables valued at CN¥3.19b due within 12 months. So it has liabilities totalling CN¥4.99b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥6.06b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sinofert Holdings has a low net debt to EBITDA ratio of only 1.0. And its EBIT covers its interest expense a whopping 17.0 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Sinofert Holdings saw its EBIT drop by 6.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Sinofert Holdings'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.

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. During the last three years, Sinofert Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Sinofert Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Sinofert Holdings's debt is making it 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. 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. Case in point: We've spotted 2 warning signs for Sinofert Holdings 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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