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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.' 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. As with many other companies China Agri-Products Exchange Limited (HKG:149) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for China Agri-Products Exchange
How Much Debt Does China Agri-Products Exchange Carry?
The image below, which you can click on for greater detail, shows that China Agri-Products Exchange had debt of HK$1.92b at the end of June 2019, a reduction from HK$2.36b over a year. On the flip side, it has HK$399.7m in cash leading to net debt of about HK$1.52b.
A Look At China Agri-Products Exchange's Liabilities
According to the last reported balance sheet, China Agri-Products Exchange had liabilities of HK$2.83b due within 12 months, and liabilities of HK$983.3m due beyond 12 months. Offsetting these obligations, it had cash of HK$399.7m as well as receivables valued at HK$121.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$3.29b.
This deficit casts a shadow over the HK$547.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Agri-Products Exchange would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.