Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.'  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 note that MMG Limited (HKG:1208) does have debt on its balance sheet.  But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow.  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.

Check out our latest analysis for MMG

What Is MMG's Debt?

The image below, which you can click on for greater detail, shows that MMG had debt of US$5.41b at the end of December 2022, a reduction from US$6.30b over a year.    On the flip side, it has US$372.2m in cash leading to net debt of about US$5.04b.  

SEHK:1208 Debt to Equity History June 29th 2023

How Strong Is MMG's Balance Sheet?

The latest balance sheet data shows that MMG had liabilities of US$1.96b due within a year, and liabilities of US$6.35b falling due after that.   Offsetting these obligations, it had cash of US$372.2m as well as receivables valued at US$383.0m due within 12 months.   So it has liabilities totalling US$7.55b more than its cash and near-term receivables, combined.  

This deficit casts a shadow over the US$2.56b company, like a colossus towering over mere mortals.   So we'd watch its balance sheet closely, without a doubt.  At the end of the day, MMG would probably need a major re-capitalization if its creditors were to demand repayment.  

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).  This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

MMG's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 2.8 times over.  Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage.        Even worse, MMG saw its EBIT tank 57% over the last 12 months.  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 future earnings, more than anything, that will determine MMG's ability to maintain a healthy balance sheet going forward.  So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.  

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it.   So we always check how much of that EBIT is translated into free cash flow.    Over the last three years, MMG actually produced more free cash flow than EBIT.  That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.  

Our View

To be frank both MMG's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels.    But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic.      Overall, it seems to us that MMG's balance sheet is really quite a risk to the business.  For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity.    When analysing debt levels, the balance sheet is the obvious place to start.  However, not all investment risk resides within the balance sheet - far from it.   Case in point: We've spotted   3 warning signs for MMG  you should be aware of, and 1 of them shouldn't be ignored.    

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.