Yantai Eddie Precision Machinery (SHSE:603638) Has A Pretty Healthy Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Yantai Eddie Precision Machinery Co., Ltd. (SHSE:603638) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 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, 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.

See our latest analysis for Yantai Eddie Precision Machinery

What Is Yantai Eddie Precision Machinery's Debt?

As you can see below, at the end of September 2023, Yantai Eddie Precision Machinery had CN¥1.48b of debt, up from CN¥1.33b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥963.6m, its net debt is less, at about CN¥514.7m.

How Healthy Is Yantai Eddie Precision Machinery's Balance Sheet?

The latest balance sheet data shows that Yantai Eddie Precision Machinery had liabilities of CN¥1.56b due within a year, and liabilities of CN¥1.00b falling due after that. On the other hand, it had cash of CN¥963.6m and CN¥1.02b worth of receivables due within a year. So it has liabilities totalling CN¥575.9m more than its cash and near-term receivables, combined.

Given Yantai Eddie Precision Machinery has a market capitalization of CN¥13.6b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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

With net debt sitting at just 0.94 times EBITDA, Yantai Eddie Precision Machinery is arguably pretty conservatively geared. And it boasts interest cover of 9.8 times, which is more than adequate. Another good sign is that Yantai Eddie Precision Machinery has been able to increase its EBIT by 28% 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 ultimately the future profitability of the business will decide if Yantai Eddie Precision Machinery can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Yantai Eddie Precision Machinery burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Yantai Eddie Precision Machinery's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. 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 Yantai Eddie Precision Machinery can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Yantai Eddie Precision Machinery's earnings per share history for free.

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.