Is JY Grandmark Holdings (HKG:2231) A Risky Investment?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies JY Grandmark Holdings Limited (HKG:2231) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for JY Grandmark Holdings

How Much Debt Does JY Grandmark Holdings Carry?

As you can see below, JY Grandmark Holdings had CN¥3.11b of debt at December 2020, down from CN¥3.30b a year prior. However, because it has a cash reserve of CN¥2.04b, its net debt is less, at about CN¥1.07b.

How Strong Is JY Grandmark Holdings' Balance Sheet?

We can see from the most recent balance sheet that JY Grandmark Holdings had liabilities of CN¥4.68b falling due within a year, and liabilities of CN¥1.76b due beyond that. Offsetting this, it had CN¥2.04b in cash and CN¥1.95b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.44b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since JY Grandmark Holdings has a market capitalization of CN¥4.32b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

JY Grandmark Holdings's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 53.5 times its interest expense, implies the debt load is as light as a peacock feather. It is just as well that JY Grandmark Holdings's load is not too heavy, because its EBIT was down 25% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is JY Grandmark Holdings'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, JY Grandmark Holdings 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, JY Grandmark Holdings's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that JY Grandmark Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 instance, we've identified 3 warning signs for JY Grandmark Holdings (2 are significant) you should be aware of.

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. 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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