We believe the Fufeng Group (HKG: 546) is taking risks with its debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that Fufeng Group Limited (HKG: 546) uses debt in his business. But should shareholders be concerned about its use of debt?

When is debt a problem?

Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first look at cash and debt levels together.

Check out our latest analysis for the Fufeng group

How much debt does the Fufeng group have?

As you can see below, Fufeng Group had CN 3.52 billion debt in June 2021, up from CN 3.94 billion the year before. However, it has CN 1.66 billion in cash offsetting this, which leads to net debt of around CN 1.86 billion.

SEHK: 546 History of debt to equity October 13, 2021

How strong is the balance sheet of the Fufeng group?

Zooming in on the latest balance sheet data, we can see that the Fufeng Group had CN 6.54 billion in liabilities due within 12 months and CN in liabilities of 1.46 billion beyond. In return, he had CN 1.66 billion in cash and CN 1.41 billion in receivables due within 12 months. Its liabilities therefore total CNS 4.92 billion more than the combination of its cash and short-term receivables.

This deficit is large compared to its market capitalization of 5.44 billion yuan, so he suggests shareholders keep an eye on the use of debt by the Fufeng Group. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).

While Fufeng Group’s low debt-to-EBITDA ratio of 0.80 suggests only a modest use of debt, the fact that EBIT only covered interest expense 6.9 times last year makes us think. But the interest payments are certainly enough to make us think about how affordable his debt is. But the bad news is that Fufeng Group has seen its EBIT drop by 17% in the past twelve months. If this rate of decline in profits continues, the company could find itself in a difficult situation. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine the ability of the Fufeng Group to maintain a healthy balance sheet in the future. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. In the past three years, Fufeng Group has recorded total negative free cash flow. Debt is typically more expensive and almost always riskier in the hands of a business with negative free cash flow. Shareholders should hope for improvement.

Our point of view

To be frank, the Fufeng Group’s EBIT growth rate and track record of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. But at least it manages its debt quite well, based on its EBITDA; it’s encouraging. Overall, it seems to us that Fufeng Group’s balance sheet is really a risk for the company. For this reason, we are quite cautious on the stock, and we believe that shareholders should closely monitor its liquidity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. To do this, you need to know the 1 warning sign we spotted with the Fufeng group.

At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.

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 does not have any position in the mentioned stocks.

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