Is Zhejiang Shibao (HKG:1057) Using Debt Sensibly?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Zhejiang Shibao Company Limited (HKG:1057) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Zhejiang Shibao

What Is Zhejiang Shibao's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2019 Zhejiang Shibao had CN¥151.8m of debt, an increase on CN¥29.1m, over one year. However, it does have CN¥201.8m in cash offsetting this, leading to net cash of CN¥50.0m.

A Look At Zhejiang Shibao's Liabilities

According to the last reported balance sheet, Zhejiang Shibao had liabilities of CN¥610.8m due within 12 months, and liabilities of CN¥55.1m due beyond 12 months. Offsetting this, it had CN¥201.8m in cash and CN¥546.9m in receivables that were due within 12 months. So it actually has CN¥82.7m more liquid assets than total liabilities.

This surplus suggests that Zhejiang Shibao has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Zhejiang Shibao has more cash than debt is arguably a good indication that it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But it is Zhejiang Shibao'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.

In the last year Zhejiang Shibao had negative earnings before interest and tax, and actually shrunk its revenue by 13%, to CN¥982m. That's not what we would hope to see.

So How Risky Is Zhejiang Shibao?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And the fact is that over the last twelve months Zhejiang Shibao lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of CN¥118m and booked a CN¥177m accounting loss. But at least it has CN¥50.0m on the balance sheet to spend on growth, near-term. Overall, its balance sheet doesn't seem overly risky, at the moment, but we're always cautious until we see the positive free cash flow. 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 Zhejiang Shibao (1 is potentially serious) 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.

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.

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