Is XCMG Construction Machinery (SZSE:000425) A Risky Investment?

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.' 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. As with many other companies XCMG Construction Machinery Co., Ltd. (SZSE:000425) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for XCMG Construction Machinery

What Is XCMG Construction Machinery's Debt?

You can click the graphic below for the historical numbers, but it shows that XCMG Construction Machinery had CN¥44.5b of debt in March 2024, down from CN¥50.4b, one year before. However, it also had CN¥21.3b in cash, and so its net debt is CN¥23.2b.

A Look At XCMG Construction Machinery's Liabilities

According to the last reported balance sheet, XCMG Construction Machinery had liabilities of CN¥84.7b due within 12 months, and liabilities of CN¥20.6b due beyond 12 months. Offsetting these obligations, it had cash of CN¥21.3b as well as receivables valued at CN¥53.9b due within 12 months. So it has liabilities totalling CN¥30.1b more than its cash and near-term receivables, combined.

This deficit isn't so bad because XCMG Construction Machinery is worth a massive CN¥75.6b, and thus could probably raise enough capital to shore up 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 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

XCMG Construction Machinery's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 5.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way XCMG Construction Machinery could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if XCMG Construction 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, XCMG Construction Machinery burned a lot of cash. 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

XCMG Construction Machinery's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. 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. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that XCMG Construction Machinery is showing 1 warning sign in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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