Is Long Yuan Construction Group (SHSE:600491) Using Too Much Debt?

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. We note that Long Yuan Construction Group Co., Ltd. (SHSE:600491) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Long Yuan Construction Group

What Is Long Yuan Construction Group's Debt?

The chart below, which you can click on for greater detail, shows that Long Yuan Construction Group had CN¥23.1b in debt in June 2024; about the same as the year before. However, it does have CN¥3.33b in cash offsetting this, leading to net debt of about CN¥19.8b.

How Strong Is Long Yuan Construction Group's Balance Sheet?

According to the last reported balance sheet, Long Yuan Construction Group had liabilities of CN¥27.0b due within 12 months, and liabilities of CN¥17.5b due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.33b as well as receivables valued at CN¥23.8b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥17.3b.

This deficit casts a shadow over the CN¥5.48b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Long Yuan Construction Group would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Weak interest cover of 0.76 times and a disturbingly high net debt to EBITDA ratio of 17.6 hit our confidence in Long Yuan Construction Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Looking on the bright side, Long Yuan Construction Group boosted its EBIT by a silky 97% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Long Yuan Construction Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last three years, Long Yuan Construction Group's free cash flow amounted to 20% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Long Yuan Construction Group's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Long Yuan Construction Group to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 Long Yuan Construction Group you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks 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.