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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Best Food Holding Company Limited (HKG:1488) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Best Food Holding
What Is Best Food Holding's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Best Food Holding had debt of CN¥683.8m, up from CN¥213.7m in one year. However, because it has a cash reserve of CN¥192.5m, its net debt is less, at about CN¥491.3m.
How Strong Is Best Food Holding's Balance Sheet?
We can see from the most recent balance sheet that Best Food Holding had liabilities of CN¥357.7m falling due within a year, and liabilities of CN¥1.22b due beyond that. Offsetting this, it had CN¥192.5m in cash and CN¥116.1m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.27b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CN¥1.43b. 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.
Weak interest cover of 0.83 times and a disturbingly high net debt to EBITDA ratio of 7.9 hit our confidence in Best Food Holding like a one-two punch to the gut. The debt burden here is substantial. Fortunately, Best Food Holding grew its EBIT by 9.8% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is Best Food Holding'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.