Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Zensun Enterprises Limited (HKG:185) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Zensun Enterprises's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Zensun Enterprises had CN¥23.8b of debt in June 2021, down from CN¥30.4b, one year before. However, because it has a cash reserve of CN¥2.42b, its net debt is less, at about CN¥21.3b.
How Strong Is Zensun Enterprises' Balance Sheet?
The latest balance sheet data shows that Zensun Enterprises had liabilities of CN¥54.4b due within a year, and liabilities of CN¥6.97b falling due after that. Offsetting this, it had CN¥2.42b in cash and CN¥140.2m in receivables that were due within 12 months. So its liabilities total CN¥58.8b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥9.53b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Zensun Enterprises 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).
As it happens Zensun Enterprises has a fairly concerning net debt to EBITDA ratio of 23.7 but very strong interest coverage of 31.9. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Zensun Enterprises's EBIT fell a jaw-dropping 63% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zensun Enterprises's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. 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.
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. We think the chances that Zensun Enterprises has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Zensun Enterprises you should be aware of, and 2 of them are potentially serious.
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. 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.
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