Here's Why AECC Aviation PowerLtd (SHSE:600893) Can Manage Its Debt Responsibly

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 note that AECC Aviation Power Co.,Ltd (SHSE:600893) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for AECC Aviation PowerLtd

How Much Debt Does AECC Aviation PowerLtd Carry?

As you can see below, at the end of June 2024, AECC Aviation PowerLtd had CN¥21.0b of debt, up from CN¥9.61b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥5.61b, its net debt is less, at about CN¥15.4b.

How Strong Is AECC Aviation PowerLtd's Balance Sheet?

The latest balance sheet data shows that AECC Aviation PowerLtd had liabilities of CN¥67.3b due within a year, and liabilities of -CN¥3.88b falling due after that. On the other hand, it had cash of CN¥5.61b and CN¥30.6b worth of receivables due within a year. So it has liabilities totalling CN¥27.2b more than its cash and near-term receivables, combined.

AECC Aviation PowerLtd has a very large market capitalization of CN¥114.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

AECC Aviation PowerLtd has a debt to EBITDA ratio of 4.3, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 10.5 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. It is well worth noting that AECC Aviation PowerLtd's EBIT shot up like bamboo after rain, gaining 60% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if AECC Aviation PowerLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, AECC Aviation PowerLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Based on what we've seen AECC Aviation PowerLtd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. Looking at all this data makes us feel a little cautious about AECC Aviation PowerLtd's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with AECC Aviation PowerLtd .

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.