Is Shanghai Daimay Automotive Interior (SHSE:603730) A Risky Investment?

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.' 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 can see that Shanghai Daimay Automotive Interior Co., Ltd (SHSE:603730) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shanghai Daimay Automotive Interior

How Much Debt Does Shanghai Daimay Automotive Interior Carry?

As you can see below, Shanghai Daimay Automotive Interior had CN¥1.35b of debt at September 2024, down from CN¥1.55b a year prior. On the flip side, it has CN¥1.13b in cash leading to net debt of about CN¥217.5m.

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How Strong Is Shanghai Daimay Automotive Interior's Balance Sheet?

The latest balance sheet data shows that Shanghai Daimay Automotive Interior had liabilities of CN¥1.31b due within a year, and liabilities of CN¥1.13b falling due after that. On the other hand, it had cash of CN¥1.13b and CN¥1.12b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥189.3m.

This state of affairs indicates that Shanghai Daimay Automotive Interior's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥14.5b company is struggling for cash, we still think it's worth monitoring its balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shanghai Daimay Automotive Interior has a low net debt to EBITDA ratio of only 0.20. And its EBIT easily covers its interest expense, being 31.8 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Shanghai Daimay Automotive Interior has boosted its EBIT by 48%, 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 Shanghai Daimay Automotive Interior 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Shanghai Daimay Automotive Interior's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Shanghai Daimay Automotive Interior's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Zooming out, Shanghai Daimay Automotive Interior seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Shanghai Daimay Automotive Interior's dividend history, without delay!

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.