Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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 can see that Golden Eagle Retail Group Limited (HKG:3308) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Golden Eagle Retail Group’s Debt?
The chart below, which you can click on for greater detail, shows that Golden Eagle Retail Group had CN¥8.38b in debt in June 2019; about the same as the year before. On the flip side, it has CN¥6.01b in cash leading to net debt of about CN¥2.38b.
A Look At Golden Eagle Retail Group’s Liabilities
Zooming in on the latest balance sheet data, we can see that Golden Eagle Retail Group had liabilities of CN¥9.22b due within 12 months and liabilities of CN¥7.60b due beyond that. On the other hand, it had cash of CN¥6.01b and CN¥910.9m worth of receivables due within a year. So its liabilities total CN¥9.89b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥11.6b, so it does suggest shareholders should keep an eye on Golden Eagle Retail Group’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Golden Eagle Retail Group has a low net debt to EBITDA ratio of only 0.87. And its EBIT covers its interest expense a whopping 10.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Golden Eagle Retail Group grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Golden Eagle Retail Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Golden Eagle Retail Group generated free cash flow amounting to a very robust 83% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Golden Eagle Retail Group’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Golden Eagle Retail Group takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for Golden Eagle Retail Group that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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