Xiamen C&D (SHSE:600153) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Xiamen C&D Inc. (SHSE:600153) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Xiamen C&D

What Is Xiamen C&D's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Xiamen C&D had debt of CN¥184.7b, up from CN¥151.4b in one year. However, because it has a cash reserve of CN¥104.0b, its net debt is less, at about CN¥80.8b.

A Look At Xiamen C&D's Liabilities

We can see from the most recent balance sheet that Xiamen C&D had liabilities of CN¥519.9b falling due within a year, and liabilities of CN¥144.2b due beyond that. Offsetting this, it had CN¥104.0b in cash and CN¥100.2b in receivables that were due within 12 months. So its liabilities total CN¥459.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥23.5b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Xiamen C&D would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Strangely Xiamen C&D has a sky high EBITDA ratio of 5.9, implying high debt, but a strong interest coverage of 11.5. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Xiamen C&D grew its EBIT by 6.3% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Xiamen C&D's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Xiamen C&D recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

While Xiamen C&D's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and interest cover were encouraging signs. When we consider all the factors discussed, it seems to us that Xiamen C&D is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Xiamen C&D (1 is a bit unpleasant!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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