We Think Cherkizovo Group (MCX:GCHE) Is Taking Some Risk With Its 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.' 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. As with many other companies Public Joint Stock Company "Cherkizovo Group" (MCX:GCHE) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Cherkizovo Group

How Much Debt Does Cherkizovo Group Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Cherkizovo Group had debt of ₽75.2b, up from ₽64.2b in one year. However, it does have ₽14.6b in cash offsetting this, leading to net debt of about ₽60.5b.

A Look At Cherkizovo Group's Liabilities

According to the last reported balance sheet, Cherkizovo Group had liabilities of ₽57.0b due within 12 months, and liabilities of ₽42.8b due beyond 12 months. Offsetting these obligations, it had cash of ₽14.6b as well as receivables valued at ₽8.15b due within 12 months. So it has liabilities totalling ₽77.0b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of ₽79.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Cherkizovo Group's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If Cherkizovo Group can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is Cherkizovo Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Cherkizovo Group's free cash flow amounted to 34% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Cherkizovo Group's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But we do take some comfort from its EBIT growth rate. When we consider all the factors discussed, it seems to us that Cherkizovo Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Cherkizovo Group that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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