David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Great Harvest Maeta Group Holdings Limited (HKG:3683) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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, 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.

See our latest analysis for Great Harvest Maeta Group Holdings

What Is Great Harvest Maeta Group Holdings's Net Debt?

As you can see below, Great Harvest Maeta Group Holdings had US$74.8m of debt at March 2019, down from US$81.2m a year prior. However, it does have US$2.60m in cash offsetting this, leading to net debt of about US$72.2m.

A Look At Great Harvest Maeta Group Holdings's Liabilities

We can see from the most recent balance sheet that Great Harvest Maeta Group Holdings had liabilities of US$18.4m falling due within a year, and liabilities of US$78.5m due beyond that. Offsetting this, it had US$2.60m in cash and US$918.0k in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$93.4m.

This deficit isn't so bad because Great Harvest Maeta Group Holdings is worth US$176.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 0.41 times and a disturbingly high net debt to EBITDA ratio of 13.3 hit our confidence in Great Harvest Maeta Group Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Looking on the bright side, Great Harvest Maeta Group Holdings boosted its EBIT by a silky 36% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Great Harvest Maeta Group Holdings will need earnings to service that debt. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Great Harvest Maeta Group Holdings actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Great Harvest Maeta Group Holdings's interest cover was a real negative on this analysis, as was its net debt to EBITDA. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Great Harvest Maeta Group Holdings is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you're interested in Great Harvest Maeta Group Holdings, you may well want to click here to check an interactive graph of its earnings per share history.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.