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.' 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 note that Beijing North Star Company Limited (HKG:588) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Beijing North Star Carry?
The image below, which you can click on for greater detail, shows that Beijing North Star had debt of CN¥28.5b at the end of September 2021, a reduction from CN¥35.5b over a year. On the flip side, it has CN¥11.6b in cash leading to net debt of about CN¥16.8b.
A Look At Beijing North Star's Liabilities
The latest balance sheet data shows that Beijing North Star had liabilities of CN¥37.2b due within a year, and liabilities of CN¥20.4b falling due after that. On the other hand, it had cash of CN¥11.6b and CN¥2.06b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥43.9b.
This deficit casts a shadow over the CN¥4.88b 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.
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.
As it happens Beijing North Star has a fairly concerning net debt to EBITDA ratio of 6.5 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, Beijing North Star's EBIT launched higher than Elon Musk, gaining a whopping 123% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Beijing North Star'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 48% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We feel some trepidation about Beijing North Star's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Beijing North Star is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Beijing North Star (2 are potentially serious!) that you should be aware of before investing here.
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.
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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