Is Golden Eagle Retail Group (HKG:3308) Using Too Much Debt?

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. We can see that Golden Eagle Retail Group Limited (HKG:3308) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Golden Eagle Retail Group

What Is Golden Eagle Retail Group's Net Debt?

As you can see below, Golden Eagle Retail Group had CN¥6.90b of debt at June 2020, down from CN¥8.38b a year prior. However, it does have CN¥5.78b in cash offsetting this, leading to net debt of about CN¥1.11b.

How Healthy Is Golden Eagle Retail Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Golden Eagle Retail Group had liabilities of CN¥12.1b due within 12 months and liabilities of CN¥3.65b due beyond that. Offsetting these obligations, it had cash of CN¥5.78b as well as receivables valued at CN¥640.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.3b.

This deficit is considerable relative to its market capitalization of CN¥10.3b, so it does suggest shareholders should keep an eye on Golden Eagle Retail Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Golden Eagle Retail Group's net debt is only 0.47 times its EBITDA. And its EBIT covers its interest expense a whopping 10.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Golden Eagle Retail Group's EBIT dived 15%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Golden Eagle Retail Group recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Both Golden Eagle Retail Group's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Looking at all this data makes us feel a little cautious about Golden Eagle Retail Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 2 warning signs for Golden Eagle Retail Group that you should be aware of.

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.

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