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 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. We can see that China Machinery Engineering Corporation (HKG:1829) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is China Machinery Engineering's Debt?
The image below, which you can click on for greater detail, shows that China Machinery Engineering had debt of CN¥555.3m at the end of December 2019, a reduction from CN¥984.8m over a year. However, its balance sheet shows it holds CN¥21.4b in cash, so it actually has CN¥20.8b net cash.
How Strong Is China Machinery Engineering's Balance Sheet?
The latest balance sheet data shows that China Machinery Engineering had liabilities of CN¥34.2b due within a year, and liabilities of CN¥1.56b falling due after that. On the other hand, it had cash of CN¥21.4b and CN¥15.8b worth of receivables due within a year. So it actually has CN¥1.39b more liquid assets than total liabilities.
This surplus suggests that China Machinery Engineering is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that China Machinery Engineering has more cash than debt is arguably a good indication that it can manage its debt safely.
Another good sign is that China Machinery Engineering has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Machinery Engineering can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While China Machinery Engineering has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, China Machinery Engineering saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
While we empathize with investors who find debt concerning, you should keep in mind that China Machinery Engineering has net cash of CN¥20.8b, as well as more liquid assets than liabilities. And we liked the look of last year's 25% year-on-year EBIT growth. So we are not troubled with China Machinery Engineering's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - China Machinery Engineering has 2 warning signs we think you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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