Beijing North Star (HKG:588) Has A Somewhat Strained Balance Sheet
Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Beijing North Star Company Limited (HKG:588) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Beijing North Star
What Is Beijing North Star's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Beijing North Star had CN¥35.5b of debt, an increase on CN¥31.7b, over one year. However, it also had CN¥14.1b in cash, and so its net debt is CN¥21.4b.
A Look At Beijing North Star's Liabilities
We can see from the most recent balance sheet that Beijing North Star had liabilities of CN¥51.0b falling due within a year, and liabilities of CN¥25.4b due beyond that. On the other hand, it had cash of CN¥14.1b and CN¥3.22b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥59.1b.
The deficiency here weighs heavily on the CN¥10.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt After all, Beijing North Star would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Beijing North Star has a debt to EBITDA ratio of 5.0, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 11.3 times its interest expense, implying the company isn't really paying full freight on that debt. Even if not sustainable, that is a good sign. It is well worth noting that Beijing North Star's EBIT shot up like bamboo after rain, gaining 63% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Beijing North Star'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.
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, Beijing North Star reported free cash flow worth 3.0% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
We'd go so far as to say Beijing North Star's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Beijing North Star has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Beijing North Star's dividend history, without delay!
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
