BAIC Motor (HKG:1958) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies BAIC Motor Corporation Limited (HKG:1958) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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, 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.

View our latest analysis for BAIC Motor

How Much Debt Does BAIC Motor Carry?

The chart below, which you can click on for greater detail, shows that BAIC Motor had CN¥17.5b in debt in March 2021; about the same as the year before. But on the other hand it also has CN¥52.3b in cash, leading to a CN¥34.8b net cash position.

How Healthy Is BAIC Motor's Balance Sheet?

According to the last reported balance sheet, BAIC Motor had liabilities of CN¥100.6b due within 12 months, and liabilities of CN¥14.9b due beyond 12 months. On the other hand, it had cash of CN¥52.3b and CN¥20.4b worth of receivables due within a year. So it has liabilities totalling CN¥42.8b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥18.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, BAIC Motor would likely require a major re-capitalisation if it had to pay its creditors today. Given that BAIC Motor has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

In addition to that, we're happy to report that BAIC Motor has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. 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 BAIC Motor 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. BAIC Motor may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, BAIC Motor recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

Although BAIC Motor's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥34.8b. And it impressed us with its EBIT growth of 34% over the last year. So we don't have any problem with BAIC Motor's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with BAIC Motor (at least 1 which doesn't sit too well with us) , 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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