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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. 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. We can see that DaChan Food (Asia) Limited (HKG:3999) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for DaChan Food (Asia)
What Is DaChan Food (Asia)'s Debt?
As you can see below, DaChan Food (Asia) had CN¥1.04b of debt at September 2019, down from CN¥1.13b a year prior. On the flip side, it has CN¥443.1m in cash leading to net debt of about CN¥599.2m.
How Strong Is DaChan Food (Asia)'s Balance Sheet?
According to the last reported balance sheet, DaChan Food (Asia) had liabilities of CN¥1.64b due within 12 months, and liabilities of CN¥480.1m due beyond 12 months. On the other hand, it had cash of CN¥443.1m and CN¥804.7m worth of receivables due within a year. So its liabilities total CN¥873.4m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥413.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. At the end of the day, DaChan Food (Asia) would probably need a major re-capitalization if its creditors were to demand repayment.
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.