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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies YAPP Automotive Systems Co., Ltd. (SHSE:603013) makes use of debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is YAPP Automotive Systems's Net Debt?
The image below, which you can click on for greater detail, shows that YAPP Automotive Systems had debt of CN¥77.8m at the end of September 2023, a reduction from CN¥181.5m over a year. But on the other hand it also has CN¥1.67b in cash, leading to a CN¥1.60b net cash position.
How Strong Is YAPP Automotive Systems' Balance Sheet?
We can see from the most recent balance sheet that YAPP Automotive Systems had liabilities of CN¥2.24b falling due within a year, and liabilities of CN¥242.0m due beyond that. On the other hand, it had cash of CN¥1.67b and CN¥1.79b worth of receivables due within a year. So it actually has CN¥985.0m more liquid assets than total liabilities.
This surplus suggests that YAPP Automotive Systems has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that YAPP Automotive Systems has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, YAPP Automotive Systems grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since YAPP Automotive Systems 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. YAPP Automotive Systems may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, YAPP Automotive Systems actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing Up
While it is always sensible to investigate a company's debt, in this case YAPP Automotive Systems has CN¥1.60b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 117% of that EBIT to free cash flow, bringing in CN¥760m. So is YAPP Automotive Systems's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for YAPP Automotive Systems you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.