Here's Why Guangxi Liugong Machinery (SZSE:000528) 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Guangxi Liugong Machinery Co., Ltd. (SZSE:000528) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Guangxi Liugong Machinery

How Much Debt Does Guangxi Liugong Machinery Carry?

The image below, which you can click on for greater detail, shows that Guangxi Liugong Machinery had debt of CN¥10.8b at the end of March 2024, a reduction from CN¥12.7b over a year. However, it does have CN¥8.86b in cash offsetting this, leading to net debt of about CN¥1.94b.

How Healthy Is Guangxi Liugong Machinery's Balance Sheet?

The latest balance sheet data shows that Guangxi Liugong Machinery had liabilities of CN¥22.2b due within a year, and liabilities of CN¥6.13b falling due after that. On the other hand, it had cash of CN¥8.86b and CN¥12.2b worth of receivables due within a year. So its liabilities total CN¥7.28b more than the combination of its cash and short-term receivables.

Guangxi Liugong Machinery has a market capitalization of CN¥20.9b, 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.

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.

Guangxi Liugong Machinery has a low net debt to EBITDA ratio of only 0.87. And its EBIT easily covers its interest expense, being 89.0 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Guangxi Liugong Machinery has boosted its EBIT by 64%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Guangxi Liugong 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Guangxi Liugong Machinery created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

The good news is that Guangxi Liugong Machinery's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Guangxi Liugong Machinery can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Guangxi Liugong Machinery is showing 2 warning signs in our investment analysis , you should know about...

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.