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. We can see that Hefei Metalforming Intelligent Manufacturing Co., Ltd. (SHSE:603011) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Hefei Metalforming Intelligent Manufacturing Carry?
The image below, which you can click on for greater detail, shows that at September 2023 Hefei Metalforming Intelligent Manufacturing had debt of CN¥637.8m, up from CN¥568.6m in one year. However, it does have CN¥604.0m in cash offsetting this, leading to net debt of about CN¥33.8m.
A Look At Hefei Metalforming Intelligent Manufacturing's Liabilities
We can see from the most recent balance sheet that Hefei Metalforming Intelligent Manufacturing had liabilities of CN¥1.86b falling due within a year, and liabilities of CN¥43.5m due beyond that. Offsetting this, it had CN¥604.0m in cash and CN¥1.11b in receivables that were due within 12 months. So its liabilities total CN¥193.0m more than the combination of its cash and short-term receivables.
Since publicly traded Hefei Metalforming Intelligent Manufacturing shares are worth a total of CN¥4.06b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Hefei Metalforming Intelligent Manufacturing has virtually no net debt, so it's fair to say it does not have a heavy debt load!
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Hefei Metalforming Intelligent Manufacturing has a low net debt to EBITDA ratio of only 0.31. And its EBIT covers its interest expense a whopping 18.3 times over. So we're pretty relaxed about its super-conservative use of debt. In fact Hefei Metalforming Intelligent Manufacturing's saving grace is its low debt levels, because its EBIT has tanked 43% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Hefei Metalforming Intelligent Manufacturing's earnings that will influence how the balance sheet holds up in the future. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hefei Metalforming Intelligent Manufacturing saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
While Hefei Metalforming Intelligent Manufacturing's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. Taking the abovementioned factors together we do think Hefei Metalforming Intelligent Manufacturing's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Hefei Metalforming Intelligent Manufacturing has 2 warning signs we think you should be aware of.
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.