The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Star Lake Bioscience Co., Inc.Zhaoqing Guangdong (SHSE:600866) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Star Lake BioscienceZhaoqing Guangdong
What Is Star Lake BioscienceZhaoqing Guangdong's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2023 Star Lake BioscienceZhaoqing Guangdong had debt of CN¥4.21b, up from CN¥419.2m in one year. On the flip side, it has CN¥1.23b in cash leading to net debt of about CN¥2.97b.
How Strong Is Star Lake BioscienceZhaoqing Guangdong's Balance Sheet?
We can see from the most recent balance sheet that Star Lake BioscienceZhaoqing Guangdong had liabilities of CN¥4.60b falling due within a year, and liabilities of CN¥1.70b due beyond that. Offsetting these obligations, it had cash of CN¥1.23b as well as receivables valued at CN¥1.02b due within 12 months. So its liabilities total CN¥4.04b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Star Lake BioscienceZhaoqing Guangdong is worth CN¥8.19b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Star Lake BioscienceZhaoqing Guangdong's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.5 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that Star Lake BioscienceZhaoqing Guangdong's EBIT was down 39% last year. 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 Star Lake BioscienceZhaoqing Guangdong's earnings that will influence how the balance sheet holds up in the future. 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 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. During the last three years, Star Lake BioscienceZhaoqing Guangdong generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Our View
Star Lake BioscienceZhaoqing Guangdong's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Star Lake BioscienceZhaoqing Guangdong is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Over time, share prices tend to follow earnings per share, so if you're interested in Star Lake BioscienceZhaoqing Guangdong, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.