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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Skyworth Group Limited (HKG:751) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 Skyworth Group had debt of CN¥8.34b at the end of December 2018, a reduction from CN¥9.70b over a year. However, it does have CN¥3.51b in cash offsetting this, leading to net debt of about CN¥4.83b.
SEHK:751 Historical Debt, November 8th 2019
How Strong Is Skyworth Group's Balance Sheet?
The latest balance sheet data shows that Skyworth Group had liabilities of CN¥24.1b due within a year, and liabilities of CN¥3.68b falling due after that. On the other hand, it had cash of CN¥3.51b and CN¥20.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.69b.
This deficit is considerable relative to its market capitalization of CN¥6.00b, so it does suggest shareholders should keep an eye on Skyworth Group's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Skyworth Group has a debt to EBITDA ratio of 4.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 10.8 is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. We also note that Skyworth Group improved its EBIT from a last year's loss to a positive CN¥603m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Skyworth Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this freereport showing analyst profit forecasts.
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 the earnings before interest and tax (EBIT) is backed by free cash flow. Considering the last year, Skyworth Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
On the face of it, Skyworth Group's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Skyworth Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Skyworth Group insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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.
