Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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 Labixiaoxin Snacks Group Limited (HKG:1262) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
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How Much Debt Does Labixiaoxin Snacks Group Carry?
As you can see below, Labixiaoxin Snacks Group had CN¥550.4m of debt at June 2022, down from CN¥593.6m a year earlier. On the flip side, it has CN¥87.7m in cash leading to net debt of about CN¥462.7m.
How Healthy Is Labixiaoxin Snacks Group’s Balance Sheet?
According to the last reported balance sheet, Labixiaoxin Snacks Group had liabilities of CN¥697.2m due within 12 months, and liabilities of CN¥15.8m due beyond 12 months. Offsetting these obligations, it had cash of CN¥87.7m as well as receivables valued at CN¥359.5m due within 12 months. So its liabilities total CN¥265.8m more than the combination of its cash and short-term receivables.
Labixiaoxin Snacks Group has a market capitalization of CN¥477.2m, so it could very likely raise cash to improve its balance sheet, if the need arises. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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) . The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Labixiaoxin Snacks Group like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. One redeeming factor for Labixiaoxin Snacks Group is that it turned last year’s EBIT loss into a gain of CN¥33m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analyzing debt. But you can’t view debt in total isolation; since Labixiaoxin Snacks Group 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 it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Labixiaoxin Snacks Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Labixiaoxin Snacks Group’s interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn’t such a worry. We’re quite clear that we consider Labixiaoxin Snacks Group to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 3 warning signs for Labixiaoxin Snacks Group (1 is a bit unpleasant!) that you should be aware of before investing here.
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% freeright now.
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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.
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