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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. As with many other companies China Yuchai International Limited (NYSE:CYD) 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is China Yuchai International's Net Debt?
As you can see below, at the end of December 2018 China Yuchai International had CN¥2.02b of debt. But on the other hand it also has CN¥6.01b in cash, leading to a CN¥3.99b net cash position.
How Healthy Is China Yuchai International's Balance Sheet?
We can see from the most recent balance sheet that China Yuchai International had liabilities of CN¥9.56b falling due within a year, and liabilities of CN¥951.2m due beyond that. On the other hand, it had cash of CN¥6.01b and CN¥7.66b worth of receivables due within a year. So it can boast CN¥3.16b more liquid assets than total liabilities.
This surplus liquidity suggests that China Yuchai International's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. 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.
On the other hand, China Yuchai International's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Yuchai International 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, China Yuchai International recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
While it is always sensible to investigate a company's debt, in this case China Yuchai International has CN¥3.99b in net cash and a decent-looking balance sheet. So we don't think China Yuchai International's use of debt is risky. Given China Yuchai International has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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