David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Yinchuan Xinhua Commercial (Group) Co., Ltd. (SHSE:600785) makes use of debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Yinchuan Xinhua Commercial (Group)
What Is Yinchuan Xinhua Commercial (Group)'s Debt?
As you can see below, at the end of March 2023, Yinchuan Xinhua Commercial (Group) had CN¥1.25b of debt, up from CN¥934.7m a year ago. Click the image for more detail. However, it does have CN¥735.4m in cash offsetting this, leading to net debt of about CN¥513.0m.
How Healthy Is Yinchuan Xinhua Commercial (Group)'s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Yinchuan Xinhua Commercial (Group) had liabilities of CN¥3.55b due within 12 months and liabilities of CN¥2.72b due beyond that. Offsetting these obligations, it had cash of CN¥735.4m as well as receivables valued at CN¥350.1m due within 12 months. So it has liabilities totalling CN¥5.18b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of CN¥3.59b, we think shareholders really should watch Yinchuan Xinhua Commercial (Group)'s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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).
Looking at its net debt to EBITDA of 1.4 and interest cover of 2.9 times, it seems to us that Yinchuan Xinhua Commercial (Group) is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. One way Yinchuan Xinhua Commercial (Group) could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Yinchuan Xinhua Commercial (Group)'s ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Yinchuan Xinhua Commercial (Group) actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
Neither Yinchuan Xinhua Commercial (Group)'s ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Yinchuan Xinhua Commercial (Group) is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Yinchuan Xinhua Commercial (Group) .
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.