Does XCMG Construction Machinery (SZSE:000425) Have A Healthy Balance Sheet?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, XCMG Construction Machinery Co., Ltd. (SZSE:000425) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for XCMG Construction Machinery

What Is XCMG Construction Machinery's Net Debt?

As you can see below, XCMG Construction Machinery had CN¥42.3b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥22.0b in cash leading to net debt of about CN¥20.3b.

A Look At XCMG Construction Machinery's Liabilities

According to the last reported balance sheet, XCMG Construction Machinery had liabilities of CN¥82.7b due within 12 months, and liabilities of CN¥24.4b due beyond 12 months. Offsetting these obligations, it had cash of CN¥22.0b as well as receivables valued at CN¥51.5b due within 12 months. So its liabilities total CN¥33.6b more than the combination of its cash and short-term receivables.

XCMG Construction Machinery has a market capitalization of CN¥69.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

XCMG Construction Machinery has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.5 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw XCMG Construction Machinery grow its EBIT by 8.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine XCMG Construction Machinery's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, XCMG Construction Machinery recorded negative free cash flow, in total. 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

XCMG Construction Machinery's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. When we consider all the factors discussed, it seems to us that XCMG Construction Machinery is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 1 warning sign for XCMG Construction Machinery that you should be aware of.

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.