Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 note that Pan Hong Holdings Group Limited (SGX:P36) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Pan Hong Holdings Group's Debt?

As you can see below, Pan Hong Holdings Group had CN¥96.4m of debt at September 2024, down from CN¥119.6m a year prior. On the flip side, it has CN¥70.3m in cash leading to net debt of about CN¥26.1m.

How Healthy Is Pan Hong Holdings Group's Balance Sheet?

We can see from the most recent balance sheet that Pan Hong Holdings Group had liabilities of CN¥1.09b falling due within a year, and liabilities of CN¥34.0m due beyond that. Offsetting these obligations, it had cash of CN¥70.3m as well as receivables valued at CN¥93.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥963.3m.

The deficiency here weighs heavily on the CN¥274.8m 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. At the end of the day, Pan Hong Holdings Group would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Pan Hong Holdings Group has net debt of just 0.81 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. The good news is that Pan Hong Holdings Group has increased its EBIT by 3.8% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Pan Hong Holdings Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Pan Hong Holdings Group actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

While Pan Hong Holdings Group's level of total liabilities has us nervous. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. We think that Pan Hong Holdings Group's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.