Here's Why Beijing North Star (HKG:588) Is Weighed Down By Its Debt Load

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.' 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. We note that Beijing North Star Company Limited (HKG:588) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 Beijing North Star

How Much Debt Does Beijing North Star Carry?

As you can see below, Beijing North Star had CN¥32.1b of debt at March 2021, down from CN¥35.3b a year prior. However, it also had CN¥10.4b in cash, and so its net debt is CN¥21.7b.

How Strong Is Beijing North Star's Balance Sheet?

We can see from the most recent balance sheet that Beijing North Star had liabilities of CN¥36.9b falling due within a year, and liabilities of CN¥23.8b due beyond that. On the other hand, it had cash of CN¥10.4b and CN¥2.30b worth of receivables due within a year. So its liabilities total CN¥47.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥7.50b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Beijing North Star 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Strangely Beijing North Star has a sky high EBITDA ratio of 13.4, implying high debt, but a strong interest coverage of 13.4. 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 Beijing North Star's EBIT was down 35% last year. 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 you can't view debt in total isolation; since Beijing North Star will need earnings to service that debt. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Beijing North Star's free cash flow amounted to 41% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Beijing North Star'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. Taking into account all the aforementioned factors, it looks like Beijing North Star has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 example Beijing North Star has 4 warning signs (and 2 which are potentially serious) we think you should know about.

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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