Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, China Shengmu Organic Milk Limited (HKG:1432) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Shengmu Organic Milk

How Much Debt Does China Shengmu Organic Milk Carry?

The image below, which you can click on for greater detail, shows that at December 2021 China Shengmu Organic Milk had debt of CN¥1.68b, up from CN¥1.37b in one year. However, because it has a cash reserve of CN¥579.6m, its net debt is less, at about CN¥1.10b.

A Look At China Shengmu Organic Milk's Liabilities

We can see from the most recent balance sheet that China Shengmu Organic Milk had liabilities of CN¥2.86b falling due within a year, and liabilities of CN¥379.6m due beyond that. Offsetting these obligations, it had cash of CN¥579.6m as well as receivables valued at CN¥320.1m due within 12 months. So it has liabilities totalling CN¥2.34b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥3.07b, so it does suggest shareholders should keep an eye on China Shengmu Organic Milk's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

China Shengmu Organic Milk has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 15.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. China Shengmu Organic Milk's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. But it is China Shengmu Organic Milk's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, China Shengmu Organic Milk's free cash flow amounted to 33% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither China Shengmu Organic Milk's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We think that China Shengmu Organic Milk's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that China Shengmu Organic Milk is showing 1 warning sign in our investment analysis , you should know about...

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. 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.