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 the more important question is: how much risk is that debt creating?

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When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is XCMG Construction Machinery's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 XCMG Construction Machinery had debt of CN¥47.6b, up from CN¥42.3b in one year. However, it does have CN¥21.4b in cash offsetting this, leading to net debt of about CN¥26.2b.

A Look At XCMG Construction Machinery's Liabilities

According to the last reported balance sheet, XCMG Construction Machinery had liabilities of CN¥85.2b due within 12 months, and liabilities of CN¥20.7b due beyond 12 months. On the other hand, it had cash of CN¥21.4b and CN¥52.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥31.9b.

While this might seem like a lot, it is not so bad since XCMG Construction Machinery has a huge market capitalization of CN¥105.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

View our latest analysis for XCMG Construction Machinery

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

XCMG Construction Machinery's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 10.6 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly XCMG Construction Machinery's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, XCMG Construction Machinery saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

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. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think XCMG Construction Machinery's debt poses some risks to the business. 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 instance, we've identified 3 warning signs for XCMG Construction Machinery (1 doesn't sit too well with us) 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.