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 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. Importantly, Beijing Capital Grand Limited (HKG:1329) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Beijing Capital Grand's Net Debt?
As you can see below, at the end of June 2021, Beijing Capital Grand had CN¥12.8b of debt, up from CN¥10.1b a year ago. Click the image for more detail. However, it does have CN¥3.40b in cash offsetting this, leading to net debt of about CN¥9.38b.
A Look At Beijing Capital Grand's Liabilities
According to the last reported balance sheet, Beijing Capital Grand had liabilities of CN¥6.91b due within 12 months, and liabilities of CN¥9.38b due beyond 12 months. Offsetting this, it had CN¥3.40b in cash and CN¥220.2m in receivables that were due within 12 months. So its liabilities total CN¥12.7b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥2.19b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Beijing Capital Grand would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Beijing Capital Grand shareholders face the double whammy of a high net debt to EBITDA ratio (42.5), and fairly weak interest coverage, since EBIT is just 0.53 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Beijing Capital Grand is that it turned last year's EBIT loss into a gain of CN¥203m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Beijing Capital Grand's earnings that will influence how the balance sheet holds up in the future. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Beijing Capital Grand actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
On the face of it, Beijing Capital Grand's interest cover 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 at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Beijing Capital Grand to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 3 warning signs for Beijing Capital Grand (2 are a bit concerning!) that you should be aware of before investing here.
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.
If you're looking for stocks to buy, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.