These 4 Measures Indicate That Xiangyang Changyuandonggu Industry (SHSE:603950) Is Using Debt Reasonably Well

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. As with many other companies Xiangyang Changyuandonggu Industry Co., Ltd. (SHSE:603950) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Xiangyang Changyuandonggu Industry

What Is Xiangyang Changyuandonggu Industry's Debt?

As you can see below, at the end of September 2024, Xiangyang Changyuandonggu Industry had CN¥770.2m of debt, up from CN¥661.2m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥531.2m, its net debt is less, at about CN¥238.9m.

A Look At Xiangyang Changyuandonggu Industry's Liabilities

Zooming in on the latest balance sheet data, we can see that Xiangyang Changyuandonggu Industry had liabilities of CN¥1.32b due within 12 months and liabilities of CN¥1.01b due beyond that. On the other hand, it had cash of CN¥531.2m and CN¥933.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥858.4m.

Of course, Xiangyang Changyuandonggu Industry has a market capitalization of CN¥5.08b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Xiangyang Changyuandonggu Industry has net debt of just 0.58 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. Another good sign is that Xiangyang Changyuandonggu Industry has been able to increase its EBIT by 30% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is Xiangyang Changyuandonggu Industry's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Xiangyang Changyuandonggu Industry actually recorded a cash outflow, overall. 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 an improvement.

Our View

The good news is that Xiangyang Changyuandonggu Industry's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Xiangyang Changyuandonggu Industry can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Xiangyang Changyuandonggu Industry (of which 1 is significant!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.