New Sparkle Roll International Group (HKG:970) Seems To Be Using A Lot Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 New Sparkle Roll International Group Limited (HKG:970) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for New Sparkle Roll International Group

What Is New Sparkle Roll International Group's Debt?

As you can see below, at the end of September 2022, New Sparkle Roll International Group had HK$946.5m of debt, up from HK$620.1m a year ago. Click the image for more detail. However, because it has a cash reserve of HK$492.4m, its net debt is less, at about HK$454.1m.

A Look At New Sparkle Roll International Group's Liabilities

According to the last reported balance sheet, New Sparkle Roll International Group had liabilities of HK$1.08b due within 12 months, and liabilities of HK$694.1m due beyond 12 months. Offsetting these obligations, it had cash of HK$492.4m as well as receivables valued at HK$69.5m due within 12 months. So its liabilities total HK$1.22b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$407.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, New Sparkle Roll International Group would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

New Sparkle Roll International Group has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.9 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, New Sparkle Roll International Group's EBIT flopped 12% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since New Sparkle Roll International Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, New Sparkle Roll International Group recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say New Sparkle Roll International Group's level of total liabilities was disappointing. But at least its net debt to EBITDA is not so bad. Overall, it seems to us that New Sparkle Roll International Group's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Case in point: We've spotted 6 warning signs for New Sparkle Roll International Group you should be aware of, and 2 of them are significant.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.