The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Luoyang Xinqianglian Slewing Bearing Co., Ltd. (SZSE:300850) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Luoyang Xinqianglian Slewing Bearing's Debt?
The image below, which you can click on for greater detail, shows that at March 2024 Luoyang Xinqianglian Slewing Bearing had debt of CN¥3.48b, up from CN¥2.85b in one year. However, because it has a cash reserve of CN¥1.30b, its net debt is less, at about CN¥2.18b.
How Strong Is Luoyang Xinqianglian Slewing Bearing's Balance Sheet?
We can see from the most recent balance sheet that Luoyang Xinqianglian Slewing Bearing had liabilities of CN¥3.07b falling due within a year, and liabilities of CN¥1.68b due beyond that. Offsetting these obligations, it had cash of CN¥1.30b as well as receivables valued at CN¥1.69b due within 12 months. So its liabilities total CN¥1.77b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Luoyang Xinqianglian Slewing Bearing is worth CN¥5.50b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Luoyang Xinqianglian Slewing Bearing has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 4.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Luoyang Xinqianglian Slewing Bearing's EBIT was pretty flat over the last year, which isn't ideal given the debt load. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Luoyang Xinqianglian Slewing Bearing's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Luoyang Xinqianglian Slewing Bearing burned a lot of cash. 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
We'd go so far as to say Luoyang Xinqianglian Slewing Bearing's conversion of EBIT to free cash flow was disappointing. But at least its level of total liabilities is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Luoyang Xinqianglian Slewing Bearing stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 instance, we've identified 3 warning signs for Luoyang Xinqianglian Slewing Bearing (1 is a bit unpleasant) you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.
