Is Sunfonda Group Holdings (HKG:1771) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Sunfonda Group Holdings Limited (HKG:1771) does carry debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sunfonda Group Holdings

What Is Sunfonda Group Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Sunfonda Group Holdings had CN¥1.90b of debt in June 2021, down from CN¥2.13b, one year before. However, it also had CN¥904.4m in cash, and so its net debt is CN¥997.6m.

A Look At Sunfonda Group Holdings' Liabilities

We can see from the most recent balance sheet that Sunfonda Group Holdings had liabilities of CN¥2.25b falling due within a year, and liabilities of CN¥583.5m due beyond that. Offsetting these obligations, it had cash of CN¥904.4m as well as receivables valued at CN¥432.1m due within 12 months. So its liabilities total CN¥1.50b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥1.12b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sunfonda Group Holdings's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 4.2 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that Sunfonda Group Holdings's EBIT shot up like bamboo after rain, gaining 78% in the last twelve months. That'll make it easier to manage its debt. 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 Sunfonda Group Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Sunfonda Group Holdings recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Sunfonda Group Holdings's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Sunfonda Group Holdings's debt poses some risks to the business. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Sunfonda Group Holdings that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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