The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that China Hainan Rubber Industry Group Co., Ltd. (SHSE:601118) does use debt in its business. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Hainan Rubber Industry Group Carry?
As you can see below, at the end of September 2023, China Hainan Rubber Industry Group had CN¥14.3b of debt, up from CN¥5.51b a year ago. Click the image for more detail. However, it also had CN¥2.97b in cash, and so its net debt is CN¥11.4b.
How Strong Is China Hainan Rubber Industry Group's Balance Sheet?
According to the last reported balance sheet, China Hainan Rubber Industry Group had liabilities of CN¥14.0b due within 12 months, and liabilities of CN¥8.18b due beyond 12 months. On the other hand, it had cash of CN¥2.97b and CN¥2.79b worth of receivables due within a year. So its liabilities total CN¥16.4b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of CN¥18.7b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Hainan Rubber Industry 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.
Over 12 months, China Hainan Rubber Industry Group reported revenue of CN¥30b, which is a gain of 93%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.
Caveat Emptor
While we can certainly appreciate China Hainan Rubber Industry Group's revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Indeed, it lost CN¥509m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. For example, we would not want to see a repeat of last year's loss of CN¥335m. So to be blunt we do think it is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that China Hainan Rubber Industry Group is showing 1 warning sign in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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