Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Sinomax Group Limited (HKG:1418) makes use of debt. 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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
The image below, which you can click on for greater detail, shows that Sinomax Group had debt of HK$786.3m at the end of June 2019, a reduction from HK$984.0m over a year. On the flip side, it has HK$459.1m in cash leading to net debt of about HK$327.2m.
SEHK:1418 Historical Debt, September 13th 2019
How Healthy Is Sinomax Group's Balance Sheet?
According to the last reported balance sheet, Sinomax Group had liabilities of HK$1.34b due within 12 months, and liabilities of HK$455.3m due beyond 12 months. Offsetting this, it had HK$459.1m in cash and HK$570.5m in receivables that were due within 12 months. So its liabilities total HK$767.9m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the HK$404.3m 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'd watch its balance sheet closely, without a doubt After all, Sinomax Group would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Sinomax Group's net debt to EBITDA ratio of 3.0, we think its super-low interest cover of 0.54 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Sinomax Group's EBIT was down 36% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sinomax Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Sinomax Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both Sinomax Group's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that Sinomax Group is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. Over time, share prices tend to follow earnings per share, so if you're interested in Sinomax Group, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
