David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that China Shengmu Organic Milk Limited (HKG:1432) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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 China Shengmu Organic Milk

What Is China Shengmu Organic Milk's Net Debt?

As you can see below, China Shengmu Organic Milk had CN¥2.00b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥1.25b in cash leading to net debt of about CN¥748.9m.

How Healthy Is China Shengmu Organic Milk's Balance Sheet?

According to the last reported balance sheet, China Shengmu Organic Milk had liabilities of CN¥2.47b due within 12 months, and liabilities of CN¥1.12b due beyond 12 months. On the other hand, it had cash of CN¥1.25b and CN¥282.8m worth of receivables due within a year. So its liabilities total CN¥2.05b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥2.29b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 Shengmu Organic Milk's net debt is only 0.91 times its EBITDA. And its EBIT easily covers its interest expense, being 12.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, China Shengmu Organic Milk's EBIT dived 16%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since China Shengmu Organic Milk 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, China Shengmu Organic Milk recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over China Shengmu Organic Milk's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Shengmu Organic Milk stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 3 warning signs for China Shengmu Organic Milk 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.