China Agri-Products Exchange (HKG:149) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies China Agri-Products Exchange Limited (HKG:149) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Agri-Products Exchange

What Is China Agri-Products Exchange's Net Debt?

As you can see below, China Agri-Products Exchange had HK$1.31b of debt at March 2024, down from HK$1.40b a year prior. However, it also had HK$243.9m in cash, and so its net debt is HK$1.07b.

How Strong Is China Agri-Products Exchange's Balance Sheet?

The latest balance sheet data shows that China Agri-Products Exchange had liabilities of HK$1.08b due within a year, and liabilities of HK$1.49b falling due after that. Offsetting these obligations, it had cash of HK$243.9m as well as receivables valued at HK$21.7m due within 12 months. So it has liabilities totalling HK$2.30b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$368.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, China Agri-Products Exchange would probably need a major re-capitalization if its creditors were to demand repayment.

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 Agri-Products Exchange shareholders face the double whammy of a high net debt to EBITDA ratio (6.2), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. The debt burden here is substantial. The good news is that China Agri-Products Exchange grew its EBIT a smooth 34% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Agri-Products Exchange 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, 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. In the last three years, China Agri-Products Exchange's free cash flow amounted to 35% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, China Agri-Products Exchange's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider China Agri-Products Exchange to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 learn about the 3 warning signs we've spotted with China Agri-Products Exchange (including 1 which doesn't sit too well with us) .

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com