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.' 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 Asia-potash International Investment (Guangzhou)Co.,Ltd. (SZSE:000893) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Asia-potash International Investment (Guangzhou)Co.Ltd Carry?
The image below, which you can click on for greater detail, shows that at March 2024 Asia-potash International Investment (Guangzhou)Co.Ltd had debt of CN¥1.84b, up from none in one year. However, it does have CN¥564.4m in cash offsetting this, leading to net debt of about CN¥1.27b.
How Strong Is Asia-potash International Investment (Guangzhou)Co.Ltd's Balance Sheet?
According to the last reported balance sheet, Asia-potash International Investment (Guangzhou)Co.Ltd had liabilities of CN¥2.08b due within 12 months, and liabilities of CN¥1.64b due beyond 12 months. Offsetting these obligations, it had cash of CN¥564.4m as well as receivables valued at CN¥127.3m due within 12 months. So its liabilities total CN¥3.04b more than the combination of its cash and short-term receivables.
Of course, Asia-potash International Investment (Guangzhou)Co.Ltd has a market capitalization of CN¥16.3b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Asia-potash International Investment (Guangzhou)Co.Ltd has a low net debt to EBITDA ratio of only 0.76. And its EBIT covers its interest expense a whopping 115 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Asia-potash International Investment (Guangzhou)Co.Ltd's load is not too heavy, because its EBIT was down 48% over the last year. 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 ultimately the future profitability of the business will decide if Asia-potash International Investment (Guangzhou)Co.Ltd can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Asia-potash International Investment (Guangzhou)Co.Ltd 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
Asia-potash International Investment (Guangzhou)Co.Ltd's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Asia-potash International Investment (Guangzhou)Co.Ltd'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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Asia-potash International Investment (Guangzhou)Co.Ltd (of which 1 makes us a bit uncomfortable!) you should know about.
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.