Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, China Mengniu Dairy Company Limited (HKG:2319) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is China Mengniu Dairy's Net Debt?

As you can see below, China Mengniu Dairy had CN¥36.2b of debt at December 2023, down from CN¥37.9b a year prior. On the flip side, it has CN¥13.7b in cash leading to net debt of about CN¥22.6b.

A Look At China Mengniu Dairy's Liabilities

Zooming in on the latest balance sheet data, we can see that China Mengniu Dairy had liabilities of CN¥32.6b due within 12 months and liabilities of CN¥32.0b due beyond that. On the other hand, it had cash of CN¥13.7b and CN¥12.5b worth of receivables due within a year. So its liabilities total CN¥38.4b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥49.0b, so it does suggest shareholders should keep an eye on China Mengniu Dairy's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

China Mengniu Dairy's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. If China Mengniu Dairy can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Mengniu Dairy can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, China Mengniu Dairy produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for China Mengniu Dairy was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that China Mengniu Dairy is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example - China Mengniu Dairy has 2 warning signs we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com