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Is China Weaving Materials Holdings (HKG:3778) A Risky Investment?

Simply Wall St

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. 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. Importantly, China Weaving Materials Holdings Limited (HKG:3778) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for China Weaving Materials Holdings

How Much Debt Does China Weaving Materials Holdings Carry?

As you can see below, at the end of June 2019, China Weaving Materials Holdings had CN¥528.3m of debt, up from CN¥500.7m a year ago. Click the image for more detail. However, it also had CN¥107.1m in cash, and so its net debt is CN¥421.2m.

SEHK:3778 Historical Debt, September 30th 2019

A Look At China Weaving Materials Holdings's Liabilities

Zooming in on the latest balance sheet data, we can see that China Weaving Materials Holdings had liabilities of CN¥817.1m due within 12 months and liabilities of CN¥208.4m due beyond that. Offsetting this, it had CN¥107.1m in cash and CN¥64.4m in receivables that were due within 12 months. So it has liabilities totalling CN¥854.0m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥381.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, China Weaving Materials Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Weaving Materials Holdings has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 3.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw China Weaving Materials Holdings grow its EBIT by 6.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Weaving Materials Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Weaving Materials Holdings recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Mulling over China Weaving Materials Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that China Weaving Materials Holdings's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.