Is iDreamSky Technology Holdings (HKG:1119) Using Too Much 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies iDreamSky Technology Holdings Limited (HKG:1119) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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 iDreamSky Technology Holdings

How Much Debt Does iDreamSky Technology Holdings Carry?

As you can see below, at the end of June 2020, iDreamSky Technology Holdings had CN¥1.89b of debt, up from CN¥996.8m a year ago. Click the image for more detail. However, it also had CN¥801.0m in cash, and so its net debt is CN¥1.09b.

How Healthy Is iDreamSky Technology Holdings's Balance Sheet?

We can see from the most recent balance sheet that iDreamSky Technology Holdings had liabilities of CN¥1.70b falling due within a year, and liabilities of CN¥1.07b due beyond that. Offsetting these obligations, it had cash of CN¥801.0m as well as receivables valued at CN¥1.32b due within 12 months. So it has liabilities totalling CN¥654.9m more than its cash and near-term receivables, combined.

Since publicly traded iDreamSky Technology Holdings shares are worth a total of CN¥5.27b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

iDreamSky Technology Holdings has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.9 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, iDreamSky Technology Holdings's EBIT flopped 19% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 iDreamSky Technology Holdings can strengthen its balance sheet over time. 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, iDreamSky Technology Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, iDreamSky Technology Holdings's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. 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 iDreamSky Technology Holdings's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with iDreamSky Technology Holdings .

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. 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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