Is BAIC Motor (HKG:1958) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that BAIC Motor Corporation Limited (HKG:1958) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 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 BAIC Motor

What Is BAIC Motor's Debt?

As you can see below, BAIC Motor had CN¥25.2b of debt at June 2020, down from CN¥27.8b a year prior. But it also has CN¥51.7b in cash to offset that, meaning it has CN¥26.5b net cash.

A Look At BAIC Motor's Liabilities

The latest balance sheet data shows that BAIC Motor had liabilities of CN¥113.7b due within a year, and liabilities of CN¥15.6b falling due after that. Offsetting these obligations, it had cash of CN¥51.7b as well as receivables valued at CN¥28.0b due within 12 months. So it has liabilities totalling CN¥49.6b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥17.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, BAIC Motor would probably need a major re-capitalization if its creditors were to demand repayment. BAIC Motor boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

On the other hand, BAIC Motor saw its EBIT drop by 7.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine BAIC Motor'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 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. During the last three years, BAIC Motor produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While BAIC Motor does have more liabilities than liquid assets, it also has net cash of CN¥26.5b. So while BAIC Motor does not have a great balance sheet, it's certainly not too bad. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with BAIC Motor , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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.
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