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. We note that China Modern Dairy Holdings Ltd. (HKG:1117) does have debt on its balance sheet. But is this debt a concern to shareholders?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Modern Dairy Holdings

What Is China Modern Dairy Holdings's Debt?

As you can see below, at the end of December 2021, China Modern Dairy Holdings had CN¥8.50b of debt, up from CN¥5.69b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.89b, its net debt is less, at about CN¥6.61b.

How Healthy Is China Modern Dairy Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Modern Dairy Holdings had liabilities of CN¥6.07b due within 12 months and liabilities of CN¥6.49b due beyond that. Offsetting this, it had CN¥1.89b in cash and CN¥1.05b in receivables that were due within 12 months. So it has liabilities totalling CN¥9.62b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥7.59b 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 Modern Dairy Holdings has a debt to EBITDA ratio of 2.9, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 13.1 is very high, suggesting that the interest expense on the debt is currently quite low. China Modern Dairy Holdings grew its EBIT by 5.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Modern Dairy Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, China Modern Dairy Holdings created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over China Modern Dairy Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Modern Dairy Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for China Modern Dairy Holdings that you should be aware of.

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% free, right now.

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.