Zensun Enterprises (HKG:185) Has No Shortage Of Debt

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.' 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. We can see that Zensun Enterprises Limited (HKG:185) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Zensun Enterprises

How Much Debt Does Zensun Enterprises Carry?

As you can see below, Zensun Enterprises had CN¥27.6b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥3.76b in cash offsetting this, leading to net debt of about CN¥23.8b.

How Healthy Is Zensun Enterprises' Balance Sheet?

According to the last reported balance sheet, Zensun Enterprises had liabilities of CN¥50.0b due within 12 months, and liabilities of CN¥9.25b due beyond 12 months. Offsetting this, it had CN¥3.76b in cash and CN¥122.8m in receivables that were due within 12 months. So it has liabilities totalling CN¥55.4b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥7.05b 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 definitely think shareholders need to watch this one closely. At the end of the day, Zensun Enterprises 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).

Strangely Zensun Enterprises has a sky high EBITDA ratio of 19.6, implying high debt, but a strong interest coverage of 20.4. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Zensun Enterprises's EBIT was down 38% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Zensun Enterprises'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Zensun Enterprises burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Zensun Enterprises's EBIT growth rate 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 interest cover is a good sign, and makes us more optimistic. Considering all the factors previously mentioned, we think that Zensun Enterprises really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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 Zensun Enterprises (including 2 which don't sit too well with us) .

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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