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Is Geely Automobile Holdings (HKG:175) Using Too Much Debt?

Simply Wall St

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. 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. We note that Geely Automobile Holdings Limited (HKG:175) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Geely Automobile Holdings

What Is Geely Automobile Holdings's Net Debt?

As you can see below, Geely Automobile Holdings had CN¥3.42b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥14.0b in cash, so it actually has CN¥10.6b net cash.

SEHK:175 Historical Debt, September 24th 2019

How Healthy Is Geely Automobile Holdings's Balance Sheet?

We can see from the most recent balance sheet that Geely Automobile Holdings had liabilities of CN¥42.2b falling due within a year, and liabilities of CN¥2.35b due beyond that. Offsetting these obligations, it had cash of CN¥14.0b as well as receivables valued at CN¥21.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.67b.

Given Geely Automobile Holdings has a humongous market capitalization of CN¥107.4b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Geely Automobile Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Geely Automobile Holdings if management cannot prevent a repeat of the 25% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Geely Automobile Holdings 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. Geely Automobile Holdings 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. Looking at the most recent three years, Geely Automobile Holdings recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

We could understand if investors are concerned about Geely Automobile Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥10.6b. So we don't have any problem with Geely Automobile Holdings's use of debt. We'd be motivated to research the stock further if we found out that Geely Automobile Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.