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. We can see that CIMC-TianDa Holdings Company Limited (HKG:445) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is CIMC-TianDa Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 CIMC-TianDa Holdings had CN¥694.9m of debt, an increase on CN¥112.7m, over one year. However, because it has a cash reserve of CN¥534.7m, its net debt is less, at about CN¥160.2m.
How Healthy Is CIMC-TianDa Holdings's Balance Sheet?
The latest balance sheet data shows that CIMC-TianDa Holdings had liabilities of CN¥2.70b due within a year, and liabilities of CN¥183.6m falling due after that. On the other hand, it had cash of CN¥534.7m and CN¥1.72b worth of receivables due within a year. So its liabilities total CN¥624.0m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because CIMC-TianDa Holdings is worth CN¥3.12b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 0.60 times EBITDA, CIMC-TianDa Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.5 times the interest expense over the last year. In addition to that, we're happy to report that CIMC-TianDa Holdings has boosted its EBIT by 35%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CIMC-TianDa 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, CIMC-TianDa Holdings recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
On our analysis CIMC-TianDa Holdings's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. Considering this range of data points, we think CIMC-TianDa Holdings is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of CIMC-TianDa Holdings's earnings per share history for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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