Is Xinxing Ductile Iron Pipes (SZSE:000778) Using Too Much Debt?

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 Xinxing Ductile Iron Pipes Co., Ltd. (SZSE:000778) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Xinxing Ductile Iron Pipes

How Much Debt Does Xinxing Ductile Iron Pipes Carry?

You can click the graphic below for the historical numbers, but it shows that Xinxing Ductile Iron Pipes had CN¥13.3b of debt in September 2024, down from CN¥15.1b, one year before. However, it does have CN¥6.22b in cash offsetting this, leading to net debt of about CN¥7.05b.

How Healthy Is Xinxing Ductile Iron Pipes' Balance Sheet?

According to the last reported balance sheet, Xinxing Ductile Iron Pipes had liabilities of CN¥17.1b due within 12 months, and liabilities of CN¥8.93b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.22b as well as receivables valued at CN¥11.2b due within 12 months. So its liabilities total CN¥8.65b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Xinxing Ductile Iron Pipes has a market capitalization of CN¥15.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).

With net debt to EBITDA of 3.5 Xinxing Ductile Iron Pipes has a fairly noticeable amount of debt. But the high interest coverage of 8.5 suggests it can easily service that debt. Shareholders should be aware that Xinxing Ductile Iron Pipes's EBIT was down 52% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Xinxing Ductile Iron Pipes 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Xinxing Ductile Iron Pipes reported free cash flow worth 11% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Xinxing Ductile Iron Pipes's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Xinxing Ductile Iron Pipes has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. We've identified 2 warning signs with Xinxing Ductile Iron Pipes , and understanding them should be part of your investment process.

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.