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.' 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. Importantly, Bright Dairy & Food Co.,Ltd (SHSE:600597) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Bright Dairy & FoodLtd's Net Debt?

As you can see below, Bright Dairy & FoodLtd had CN¥3.06b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥2.37b in cash leading to net debt of about CN¥692.2m.

How Strong Is Bright Dairy & FoodLtd's Balance Sheet?

We can see from the most recent balance sheet that Bright Dairy & FoodLtd had liabilities of CN¥9.02b falling due within a year, and liabilities of CN¥2.49b due beyond that. Offsetting this, it had CN¥2.37b in cash and CN¥2.14b in receivables that were due within 12 months. So its liabilities total CN¥7.00b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥11.3b, so it does suggest shareholders should keep an eye on Bright Dairy & FoodLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Bright Dairy & FoodLtd's low debt to EBITDA ratio of 0.36 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Bright Dairy & FoodLtd's EBIT shot up like bamboo after rain, gaining 31% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Bright Dairy & FoodLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Bright Dairy & FoodLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We feel some trepidation about Bright Dairy & FoodLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its EBIT growth rate and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Bright Dairy & FoodLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Bright Dairy & FoodLtd (of which 1 makes us a bit uncomfortable!) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com