Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 China Feihe Limited (HKG:6186) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is China Feihe's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2023 China Feihe had debt of CN¥1.38b, up from CN¥1.31b in one year. But on the other hand it also has CN¥19.1b in cash, leading to a CN¥17.7b net cash position.
How Healthy Is China Feihe's Balance Sheet?
According to the last reported balance sheet, China Feihe had liabilities of CN¥7.38b due within 12 months, and liabilities of CN¥2.48b due beyond 12 months. Offsetting these obligations, it had cash of CN¥19.1b as well as receivables valued at CN¥431.2m due within 12 months. So it actually has CN¥9.68b more liquid assets than total liabilities.
It's good to see that China Feihe has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that China Feihe has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for China Feihe if management cannot prevent a repeat of the 29% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Feihe's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While China Feihe has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, China Feihe recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Summing Up
While it is always sensible to investigate a company's debt, in this case China Feihe has CN¥17.7b in net cash and a decent-looking balance sheet. So we are not troubled with China Feihe's debt use. 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. We've identified 1 warning sign with China Feihe , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.