Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies China Ruyi Holdings Limited (HKG:136) uses debt. But should shareholders worry about its use of debt?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for China Ruyi Holdings
How much debt does China Ruyi Holdings have?
As you can see below, at the end of December 2021, China Ruyi Holdings had a debt of 1.52 billion Canadian yen, compared to none a year ago. Click on the image for more details. On the other hand, it has 1.18 billion yen in cash, resulting in a net debt of around 338.7 million yen.
A look at the liabilities of China Ruyi Holdings
According to the latest published balance sheet, China Ruyi Holdings had liabilities of 1.72 billion Canadian yen due within 12 months and liabilities of 3.28 billion Canadian yen due beyond 12 months. In return, it had 1.18 billion yen in cash and 1.30 billion yen in debt due within 12 months. Thus, its liabilities total 2.52 billion Canadian yen more than the combination of its cash and short-term receivables.
Given that China Ruyi Holdings has a market capitalization of 15.5 billion Canadian yen, it’s hard to believe that these liabilities pose a big threat. That said, it is clear that we must continue to monitor its record, lest it deteriorate.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
China Ruyi Holdings’ net debt is only 0.34 times its EBITDA. And its EBIT covers its interest costs 29.0 times. So we’re pretty relaxed about his super-conservative use of debt. Even more impressive is the fact that China Ruyi Holdings increased its EBIT by 13,028% year-over-year. This boost will make it even easier to pay off debt in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in total isolation; since China Ruyi Holdings will need revenue to repay this debt. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, China Ruyi Holdings has had negative free cash flow, overall. Debt is generally more expensive and almost always riskier in the hands of a company with negative free cash flow. Shareholders should hope for an improvement.
Our point of view
China Ruyi Holdings’ interest coverage suggests they can manage their debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But we have to admit that we see that converting it from EBIT to free cash flow has the opposite effect. All in all, it looks like China Ruyi Holdings can comfortably manage its current level of debt. On the plus side, this leverage can increase shareholder returns, but the potential downside is greater risk of loss, so it’s worth keeping an eye on the balance sheet. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Know that China Ruyi Holdings shows 2 warning signs in our investment analysis you should know…
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.