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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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Huazhong In-Vehicle Holdings Company Limited (HKG:6830) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Huazhong In-Vehicle Holdings
What Is Huazhong In-Vehicle Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Huazhong In-Vehicle Holdings had debt of CN¥928.1m, up from CN¥791.1m in one year. However, because it has a cash reserve of CN¥90.1m, its net debt is less, at about CN¥838.0m.
How Healthy Is Huazhong In-Vehicle Holdings's Balance Sheet?
According to the last reported balance sheet, Huazhong In-Vehicle Holdings had liabilities of CN¥2.00b due within 12 months, and liabilities of CN¥247.3m due beyond 12 months. On the other hand, it had cash of CN¥90.1m and CN¥859.1m worth of receivables due within a year. So its liabilities total CN¥1.29b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥1.69b, so it does suggest shareholders should keep an eye on Huazhong In-Vehicle Holdings's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.