Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 COFCO Joycome Foods Limited (HKG:1610) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for COFCO Joycome Foods

How Much Debt Does COFCO Joycome Foods Carry?

You can click the graphic below for the historical numbers, but it shows that COFCO Joycome Foods had CN¥6.29b of debt in December 2021, down from CN¥8.49b, one year before. However, it also had CN¥1.06b in cash, and so its net debt is CN¥5.24b.

How Healthy Is COFCO Joycome Foods' Balance Sheet?

According to the last reported balance sheet, COFCO Joycome Foods had liabilities of CN¥8.51b due within 12 months, and liabilities of CN¥912.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.06b as well as receivables valued at CN¥1.40b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.97b.

This deficit is considerable relative to its market capitalization of CN¥10.9b, so it does suggest shareholders should keep an eye on COFCO Joycome Foods' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

COFCO Joycome Foods's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 20.2 times, makes us even more comfortable. Importantly, COFCO Joycome Foods's EBIT fell a jaw-dropping 64% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine COFCO Joycome Foods's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, COFCO Joycome Foods reported free cash flow worth 8.1% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say COFCO Joycome Foods's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that COFCO Joycome Foods has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with COFCO Joycome Foods , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.