Is Pou Sheng International (Holdings) (HKG:3813) 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. As with many other companies Pou Sheng International (Holdings) Limited (HKG:3813) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

See our latest analysis for Pou Sheng International (Holdings)

What Is Pou Sheng International (Holdings)'s Net Debt?

As you can see below, Pou Sheng International (Holdings) had CN¥1.92b of debt at June 2021, down from CN¥2.74b a year prior. However, because it has a cash reserve of CN¥1.79b, its net debt is less, at about CN¥125.7m.

A Look At Pou Sheng International (Holdings)'s Liabilities

The latest balance sheet data shows that Pou Sheng International (Holdings) had liabilities of CN¥6.31b due within a year, and liabilities of CN¥2.18b falling due after that. On the other hand, it had cash of CN¥1.79b and CN¥3.35b worth of receivables due within a year. So its liabilities total CN¥3.35b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥5.20b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

Pou Sheng International (Holdings) has very modest net debt, giving rise to a debt to EBITDA ratio of 0.06. And this impression is enhanced by its strong EBIT which covers interest costs 7.1 times. On top of that, Pou Sheng International (Holdings) grew its EBIT by 51% over the last twelve months, and that growth will make it easier to handle its debt. 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 Pou Sheng International (Holdings) 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Pou Sheng International (Holdings) actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Pou Sheng International (Holdings)'s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. Zooming out, Pou Sheng International (Holdings) seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Pou Sheng International (Holdings) you should know about.

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.

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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