Here's Why Guangxi Liugong Machinery (SZSE:000528) Can Manage Its Debt Responsibly

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 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. We note that Guangxi Liugong Machinery Co., Ltd. (SZSE:000528) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Guangxi Liugong Machinery

What Is Guangxi Liugong Machinery's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Guangxi Liugong Machinery had CN¥9.22b of debt in September 2024, down from CN¥12.1b, one year before. However, because it has a cash reserve of CN¥8.02b, its net debt is less, at about CN¥1.20b.

A Look At Guangxi Liugong Machinery's Liabilities

The latest balance sheet data shows that Guangxi Liugong Machinery had liabilities of CN¥22.0b due within a year, and liabilities of CN¥5.92b falling due after that. Offsetting these obligations, it had cash of CN¥8.02b as well as receivables valued at CN¥12.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.22b.

This deficit isn't so bad because Guangxi Liugong Machinery is worth CN¥22.2b, 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 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.

Guangxi Liugong Machinery's net debt is only 0.46 times its EBITDA. And its EBIT easily covers its interest expense, being 26.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Guangxi Liugong Machinery grew its EBIT by 59% over the last twelve months, and that growth will make it easier to handle its debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Guangxi Liugong Machinery's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

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. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. When we consider the range of factors above, it looks like Guangxi Liugong Machinery is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Guangxi Liugong Machinery 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.