Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 China Mengniu Dairy Company Limited (HKG:2319) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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 Debt?
You can click the graphic below for the historical numbers, but it shows that China Mengniu Dairy had CN¥34.6b of debt in December 2024, down from CN¥36.2b, one year before. However, it does have CN¥25.5b in cash offsetting this, leading to net debt of about CN¥9.16b.
How Healthy Is China Mengniu Dairy's Balance Sheet?
According to the last reported balance sheet, China Mengniu Dairy had liabilities of CN¥37.0b due within 12 months, and liabilities of CN¥21.3b due beyond 12 months. Offsetting this, it had CN¥25.5b in cash and CN¥3.26b in receivables that were due within 12 months. So its liabilities total CN¥29.5b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because China Mengniu Dairy is worth CN¥71.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
See our latest analysis for China Mengniu Dairy
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 has a low net debt to EBITDA ratio of only 1.0. And its EBIT covers its interest expense a whopping 111 times over. So we're pretty relaxed about its super-conservative use of debt. Also good is that China Mengniu Dairy grew its EBIT at 14% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, China Mengniu Dairy's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
China Mengniu Dairy's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And its net debt to EBITDA is good too. All these things considered, it appears that China Mengniu Dairy can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for China Mengniu Dairy that you should be aware of.
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.
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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.