Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Jiangsu Etern Company Limited (SHSE:600105) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Jiangsu Etern's Net Debt?
As you can see below, at the end of June 2024, Jiangsu Etern had CN¥3.64b of debt, up from CN¥2.48b a year ago. Click the image for more detail. However, it also had CN¥1.71b in cash, and so its net debt is CN¥1.93b.
A Look At Jiangsu Etern's Liabilities
We can see from the most recent balance sheet that Jiangsu Etern had liabilities of CN¥4.29b falling due within a year, and liabilities of CN¥991.5m due beyond that. Offsetting this, it had CN¥1.71b in cash and CN¥1.41b in receivables that were due within 12 months. So its liabilities total CN¥2.17b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Jiangsu Etern is worth CN¥5.67b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Jiangsu Etern's debt to EBITDA ratio of 6.4 suggests a heavy debt load, its interest coverage of 7.5 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. Pleasingly, Jiangsu Etern is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 405% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Jiangsu Etern 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, Jiangsu Etern burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Neither Jiangsu Etern's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Jiangsu Etern's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Jiangsu Etern (2 are a bit unpleasant) you should be aware of.
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.
