Does Red Star Macalline Group (HKG:1528) Have A Healthy Balance Sheet?

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 Red Star Macalline Group Corporation Ltd. (HKG:1528) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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, 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 Red Star Macalline Group

How Much Debt Does Red Star Macalline Group Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Red Star Macalline Group had debt of CN¥49.4b, up from CN¥44.3b in one year. However, because it has a cash reserve of CN¥7.80b, its net debt is less, at about CN¥41.6b.

How Strong Is Red Star Macalline Group's Balance Sheet?

According to the last reported balance sheet, Red Star Macalline Group had liabilities of CN¥31.3b due within 12 months, and liabilities of CN¥48.7b due beyond 12 months. Offsetting these obligations, it had cash of CN¥7.80b as well as receivables valued at CN¥4.81b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥67.4b.

The deficiency here weighs heavily on the CN¥30.0b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Red Star Macalline Group would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

With a net debt to EBITDA ratio of 8.2, it's fair to say Red Star Macalline Group does have a significant amount of debt. However, its interest coverage of 2.5 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that Red Star Macalline Group saw its EBIT drop by 18% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Red Star Macalline Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Red Star Macalline Group 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, Red Star Macalline Group's conversion of EBIT to free cash flow 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. And furthermore, its EBIT growth rate also fails to instill confidence. It looks to us like Red Star Macalline Group carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Red Star Macalline Group is showing 4 warning signs in our investment analysis , and 1 of those is significant...

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.

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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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