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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.' 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. Importantly, China Agri-Industries Holdings Limited (HKG:606) does carry debt. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for China Agri-Industries Holdings
What Is China Agri-Industries Holdings's Debt?
The image below, which you can click on for greater detail, shows that at December 2018 China Agri-Industries Holdings had debt of HK$22.4b, up from HK$19.9b in one year. However, it does have HK$9.24b in cash offsetting this, leading to net debt of about HK$13.2b.
How Healthy Is China Agri-Industries Holdings's Balance Sheet?
We can see from the most recent balance sheet that China Agri-Industries Holdings had liabilities of HK$35.9b falling due within a year, and liabilities of HK$1.42b due beyond that. Offsetting these obligations, it had cash of HK$9.24b as well as receivables valued at HK$9.69b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$18.4b.
When you consider that this deficiency exceeds the company's HK$13.0b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).