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. We note that Century Ginwa Retail Holdings Limited (HKG:162) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Century Ginwa Retail Holdings’s Net Debt?
As you can see below, Century Ginwa Retail Holdings had CN¥2.36b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had CN¥544.7m in cash, and so its net debt is CN¥1.82b.
How Strong Is Century Ginwa Retail Holdings’s Balance Sheet?
The latest balance sheet data shows that Century Ginwa Retail Holdings had liabilities of CN¥2.04b due within a year, and liabilities of CN¥2.13b falling due after that. Offsetting these obligations, it had cash of CN¥544.7m as well as receivables valued at CN¥444.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.18b.
This deficit casts a shadow over the CN¥420.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Century Ginwa Retail Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.31 times and a disturbingly high net debt to EBITDA ratio of 11.1 hit our confidence in Century Ginwa Retail Holdings like a one-two punch to the gut. The debt burden here is substantial. Even worse, Century Ginwa Retail Holdings saw its EBIT tank 84% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But it is Century Ginwa Retail 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 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. Over the last three years, Century Ginwa Retail Holdings reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, Century Ginwa Retail Holdings’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. And even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Century Ginwa Retail Holdings really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Even though Century Ginwa Retail Holdings lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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