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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Lifestyle China Group Limited (HKG:2136) makes use of debt. 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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Lifestyle China Group Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Lifestyle China Group had debt of CN¥2.34b, up from CN¥1.77b in one year. However, it does have CN¥2.06b in cash offsetting this, leading to net debt of about CN¥274.8m.
How Healthy Is Lifestyle China Group's Balance Sheet?
The latest balance sheet data shows that Lifestyle China Group had liabilities of CN¥919.7m due within a year, and liabilities of CN¥2.93b falling due after that. Offsetting this, it had CN¥2.06b in cash and CN¥144.7m in receivables that were due within 12 months. So its liabilities total CN¥1.64b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Lifestyle China Group has a market capitalization of CN¥3.24b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
Lifestyle China Group has net debt of just 0.95 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. Lifestyle China Group's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Lifestyle China Group'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Lifestyle China Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Lifestyle China Group's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Lifestyle China Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in Lifestyle China Group, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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