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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 China Yuchai International Limited (NYSE:CYD) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is China Yuchai International's Net Debt?
As you can see below, at the end of December 2020, China Yuchai International had CN¥2.23b of debt, up from CN¥2.06b a year ago. Click the image for more detail. But on the other hand it also has CN¥6.14b in cash, leading to a CN¥3.91b net cash position.
How Strong Is China Yuchai International's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Yuchai International had liabilities of CN¥13.1b due within 12 months and liabilities of CN¥1.41b due beyond that. Offsetting these obligations, it had cash of CN¥6.14b as well as receivables valued at CN¥8.39b due within 12 months. So these liquid assets roughly match the total liabilities.
Having regard to China Yuchai International's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥4.20b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that China Yuchai International has more cash than debt is arguably a good indication that it can manage its debt safely.
Fortunately, China Yuchai International grew its EBIT by 7.1% in the last year, making that debt load look even more manageable. 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 Yuchai International 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While China Yuchai International 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. Looking at the most recent three years, China Yuchai International recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While it is always sensible to investigate a company's debt, in this case China Yuchai International has CN¥3.91b in net cash and a decent-looking balance sheet. On top of that, it increased its EBIT by 7.1% in the last twelve months. So we are not troubled with China Yuchai International's debt use. 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. To that end, you should be aware of the 1 warning sign we've spotted with China Yuchai International .
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.
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. 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.
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