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 Yinchuan Xinhua Commercial (Group) Co., Ltd. (SHSE:600785) makes use of debt. But the real question is whether this debt is making the company risky.
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Yinchuan Xinhua Commercial (Group)'s Debt?
The image below, which you can click on for greater detail, shows that Yinchuan Xinhua Commercial (Group) had debt of CN¥1.02b at the end of September 2023, a reduction from CN¥1.18b over a year. However, it does have CN¥547.9m in cash offsetting this, leading to net debt of about CN¥470.5m.
How Healthy Is Yinchuan Xinhua Commercial (Group)'s Balance Sheet?
The latest balance sheet data shows that Yinchuan Xinhua Commercial (Group) had liabilities of CN¥3.31b due within a year, and liabilities of CN¥2.69b falling due after that. Offsetting this, it had CN¥547.9m in cash and CN¥327.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.12b.
When you consider that this deficiency exceeds the company's CN¥3.65b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Yinchuan Xinhua Commercial (Group) has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 1.8 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Yinchuan Xinhua Commercial (Group) grew its EBIT by 3.8% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Yinchuan Xinhua Commercial (Group) actually produced more free cash flow than EBIT. 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 cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Yinchuan Xinhua Commercial (Group) is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in Yinchuan Xinhua Commercial (Group), you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.