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. As with many other companies China Yuchai International Limited (NYSE:CYD) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 China Yuchai International’s Debt?
The image below, which you can click on for greater detail, shows that at December 2018 China Yuchai International had debt of CN¥2.02b, up from CN¥1.63b in one year. But on the other hand it also has CN¥6.01b in cash, leading to a CN¥3.99b net cash position.
A Look At China Yuchai International’s Liabilities
According to the last reported balance sheet, China Yuchai International had liabilities of CN¥9.56b due within 12 months, and liabilities of CN¥951.2m due beyond 12 months. Offsetting this, it had CN¥6.01b in cash and CN¥7.66b in receivables that were due within 12 months. So it actually has CN¥3.16b more liquid assets than total liabilities.
This luscious liquidity implies that China Yuchai International’s balance sheet is sturdy like a giant sequoia tree. On this view, it seems its balance sheet is as strong as a black-belt karate master. 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.
But the bad news is that China Yuchai International has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. During the last three years, China Yuchai International produced sturdy free cash flow equating to 76% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that China Yuchai International has net cash of CN¥4.0b, as well as more liquid assets than liabilities. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in CN¥82m. So is China Yuchai International’s debt a risk? It doesn’t seem so to us. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check China Yuchai International’s dividend history, without delay!
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.
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