Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We note that Beijing North Star Company Limited (HKG: 588) has debt on its balance sheet. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first look at cash and debt levels together.
Check out our latest analysis for Beijing North Star
How much debt does Beijing’s North Star carry?
The image below, which you can click for more details, shows Beijing North Star owed CN 28.5 billion in debt at the end of September 2021, a reduction from CN’s 35.5 billion. over a year. On the other hand, he has CN 11.6 billion in cash, resulting in a net debt of around CN 16.8 billion.
A look at the responsibilities of Beijing North Star
The latest balance sheet data shows that Beijing North Star had CN 37.2 billion in debt due within one year, and CN 20.4 billion in debt due thereafter. On the other hand, he had CN 11.6 billion in cash and CN 2.06 billion in receivables due within one year. Thus, its liabilities exceed the sum of its cash and its (short-term) receivables by 43.9 billion yen.
This deficit casts a shadow over the CN Â¥ 4.88b company, like a colossus towering over mere mortals. We therefore believe that shareholders should watch it closely. After all, Beijing North Star would likely need a major recapitalization if it were to pay its creditors today.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
As it turns out, Beijing North Star has a rather worrying net debt to EBITDA ratio of 6.5 but very strong interest coverage of 1k. So either he has access to very cheap long-term debt or his interest charges will go up! Notably, Beijing North Star’s EBIT was higher than Elon Musk’s, gaining a whopping 123% from last year. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is the earnings of Beijing North Star that will influence the performance of the balance sheet in the future. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We must therefore clearly verify whether this EBIT generates a corresponding free cash flow. Over the past three years, Beijing North Star’s free cash flow has been 48% of its EBIT, less than we expected. It’s not great when it comes to paying down debt.
Our point of view
We feel some trepidation about the difficulty level of Beijing North Star’s total liabilities, but we also have some bright spots to focus on. For example, its interest coverage and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Beijing North Star is taking risks with its recourse to debt. While this debt may increase returns, we believe the company now has sufficient leverage. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 4 warning signs for Beijing North Star (2 are potentially serious!) Which you should know before investing here.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page. free list of growing companies that have net cash on the balance sheet.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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