These 4 Measures Indicate That Loncin Motor (SHSE:603766) Is Using Debt Safely

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Loncin Motor Co., Ltd. (SHSE:603766) does use debt in its business. But should shareholders be worried about its use of debt?

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, 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.

Check out our latest analysis for Loncin Motor

What Is Loncin Motor's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Loncin Motor had debt of CN¥674.7m, up from CN¥630.6m in one year. However, its balance sheet shows it holds CN¥5.15b in cash, so it actually has CN¥4.48b net cash.

How Healthy Is Loncin Motor's Balance Sheet?

We can see from the most recent balance sheet that Loncin Motor had liabilities of CN¥4.56b falling due within a year, and liabilities of CN¥597.0m due beyond that. Offsetting this, it had CN¥5.15b in cash and CN¥1.97b in receivables that were due within 12 months. So it actually has CN¥1.97b more liquid assets than total liabilities.

It's good to see that Loncin Motor has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Loncin Motor has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that Loncin Motor saw its EBIT decline by 6.0% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Loncin Motor will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Loncin Motor 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. Happily for any shareholders, Loncin Motor actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Loncin Motor has net cash of CN¥4.48b, as well as more liquid assets than liabilities. The cherry on top was that in converted 161% of that EBIT to free cash flow, bringing in CN¥2.0b. So is Loncin Motor's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Loncin Motor has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.

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.

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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.