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.’ 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 note that China Enterprise Company Limited (SHSE:600675) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for China Enterprise
How Much Debt Does China Enterprise Carry?
The image below, which you can click on for greater detail, shows that China Enterprise had debt of CN¥20.8b at the end of June 2024, a reduction from CN¥24.2b over a year. However, it also had CN¥14.1b in cash, and so its net debt is CN¥6.68b.
How Healthy Is China Enterprise’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Enterprise had liabilities of CN¥20.3b due within 12 months and liabilities of CN¥19.2b due beyond that. Offsetting these obligations, it had cash of CN¥14.1b as well as receivables valued at CN¥534.5m due within 12 months. So it has liabilities totalling CN¥24.9b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s CN¥18.0b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
China Enterprise’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 3.1 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. However, it should be some comfort for shareholders to recall that China Enterprise actually grew its EBIT by a hefty 770%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since China Enterprise will need earnings to service that debt. 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, China Enterprise actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
While China Enterprise’s level of total liabilities has us nervous. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. We think that China Enterprise’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. These risks can be hard to spot. Every company has them, and we’ve spotted 5 warning signs for China Enterprise (of which 2 don’t sit too well with us!) you should know about.
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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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.
