These 4 Measures Indicate That Pou Sheng International (Holdings) (HKG:3813) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Pou Sheng International (Holdings) Limited (HKG:3813) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Pou Sheng International (Holdings)

How Much Debt Does Pou Sheng International (Holdings) Carry?

As you can see below, Pou Sheng International (Holdings) had CN¥1.95b of debt at December 2020, down from CN¥3.55b a year prior. However, because it has a cash reserve of CN¥1.74b, its net debt is less, at about CN¥206.4m.

How Strong Is Pou Sheng International (Holdings)'s Balance Sheet?

The latest balance sheet data shows that Pou Sheng International (Holdings) had liabilities of CN¥7.00b due within a year, and liabilities of CN¥2.14b falling due after that. On the other hand, it had cash of CN¥1.74b and CN¥3.36b worth of receivables due within a year. So its liabilities total CN¥4.04b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Pou Sheng International (Holdings) has a market capitalization of CN¥7.73b, 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.

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

Looking at its net debt to EBITDA of 0.17 and interest cover of 2.8 times, it seems to us that Pou Sheng International (Holdings) is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Pou Sheng International (Holdings)'s EBIT fell a jaw-dropping 56% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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're focused on the future you can check out this free report showing analyst profit forecasts.

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 conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

While Pou Sheng International (Holdings)'s EBIT growth rate has us nervous. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. We think that Pou Sheng International (Holdings)'s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Pou Sheng International (Holdings) has 1 warning sign we think you should be aware of.

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.

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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. 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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