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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 note that China Sandi Holdings Limited (HKG:910) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for China Sandi Holdings
What Is China Sandi Holdings's Debt?
As you can see below, at the end of June 2019, China Sandi Holdings had CN¥5.20b of debt, up from CN¥842.9m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.21b, its net debt is less, at about CN¥3.99b.
How Healthy Is China Sandi Holdings's Balance Sheet?
We can see from the most recent balance sheet that China Sandi Holdings had liabilities of CN¥11.0b falling due within a year, and liabilities of CN¥4.31b due beyond that. Offsetting these obligations, it had cash of CN¥1.21b as well as receivables valued at CN¥2.76b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥11.4b.
The deficiency here weighs heavily on the CN¥2.74b 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, China Sandi Holdings 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.