Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Yunnan Yuntianhua Co., Ltd. (SHSE:600096) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Yunnan Yuntianhua's Debt?
The image below, which you can click on for greater detail, shows that Yunnan Yuntianhua had debt of CN¥22.2b at the end of September 2023, a reduction from CN¥28.6b over a year. However, because it has a cash reserve of CN¥8.94b, its net debt is less, at about CN¥13.3b.
A Look At Yunnan Yuntianhua's Liabilities
According to the last reported balance sheet, Yunnan Yuntianhua had liabilities of CN¥22.2b due within 12 months, and liabilities of CN¥12.6b due beyond 12 months. On the other hand, it had cash of CN¥8.94b and CN¥3.80b worth of receivables due within a year. So it has liabilities totalling CN¥22.1b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CN¥35.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.
Yunnan Yuntianhua's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its commanding EBIT of 17.2 times its interest expense, implies the debt load is as light as a peacock feather. The modesty of its debt load may become crucial for Yunnan Yuntianhua if management cannot prevent a repeat of the 26% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Yunnan Yuntianhua can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Yunnan Yuntianhua 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
Yunnan Yuntianhua's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Yunnan Yuntianhua's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Yunnan Yuntianhua has 2 warning signs we think 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.
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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.