David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Greentown China Holdings Limited (HKG:3900) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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.
What Is Greentown China Holdings's Debt?
As you can see below, at the end of June 2021, Greentown China Holdings had CN¥127.9b of debt, up from CN¥111.9b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥56.6b, its net debt is less, at about CN¥71.4b.
How Strong Is Greentown China Holdings' Balance Sheet?
We can see from the most recent balance sheet that Greentown China Holdings had liabilities of CN¥287.2b falling due within a year, and liabilities of CN¥103.2b due beyond that. On the other hand, it had cash of CN¥56.6b and CN¥78.7b worth of receivables due within a year. So it has liabilities totalling CN¥255.2b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥26.2b 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. After all, Greentown China Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
As it happens Greentown China Holdings has a fairly concerning net debt to EBITDA ratio of 6.7 but very strong interest coverage of 93.2. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. One way Greentown China Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 18%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Greentown China Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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 that EBIT is backed by free cash flow. During the last three years, Greentown China Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Greentown China Holdings'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. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Greentown China Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 2 warning signs we've spotted with Greentown China Holdings (including 1 which doesn'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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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.