Here's Why Hunan Yujing MachineryLtd (SZSE:002943) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Hunan Yujing Machinery Co.,Ltd (SZSE:002943) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hunan Yujing MachineryLtd

How Much Debt Does Hunan Yujing MachineryLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Hunan Yujing MachineryLtd had debt of CN¥314.6m, up from CN¥214.3m in one year. However, it does have CN¥193.2m in cash offsetting this, leading to net debt of about CN¥121.4m.

A Look At Hunan Yujing MachineryLtd's Liabilities

According to the last reported balance sheet, Hunan Yujing MachineryLtd had liabilities of CN¥1.33b due within 12 months, and liabilities of CN¥181.2m due beyond 12 months. On the other hand, it had cash of CN¥193.2m and CN¥910.8m worth of receivables due within a year. So it has liabilities totalling CN¥406.5m more than its cash and near-term receivables, combined.

Of course, Hunan Yujing MachineryLtd has a market capitalization of CN¥3.95b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Hunan Yujing MachineryLtd's net debt is only 0.75 times its EBITDA. And its EBIT covers its interest expense a whopping 44.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Hunan Yujing MachineryLtd grew its EBIT by 85% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hunan Yujing MachineryLtd can strengthen its balance sheet over time. 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. Over the last two years, Hunan Yujing MachineryLtd 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

Hunan Yujing MachineryLtd's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Hunan Yujing MachineryLtd can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Hunan Yujing MachineryLtd (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.