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.' 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. As with many other companies Guangzhou Automobile Group Co., Ltd. (HKG:2238) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Guangzhou Automobile Group's Debt?
The image below, which you can click on for greater detail, shows that at March 2021 Guangzhou Automobile Group had debt of CN¥14.9b, up from CN¥11.6b in one year. But it also has CN¥22.2b in cash to offset that, meaning it has CN¥7.38b net cash.
A Look At Guangzhou Automobile Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Guangzhou Automobile Group had liabilities of CN¥36.7b due within 12 months and liabilities of CN¥15.2b due beyond that. Offsetting these obligations, it had cash of CN¥22.2b as well as receivables valued at CN¥11.3b due within 12 months. So its liabilities total CN¥18.3b more than the combination of its cash and short-term receivables.
Of course, Guangzhou Automobile Group has a titanic market capitalization of CN¥134.2b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Guangzhou Automobile Group boasts net cash, so it's fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guangzhou Automobile Group 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.
In the last year Guangzhou Automobile Group wasn't profitable at an EBIT level, but managed to grow its revenue by 22%, to CN¥68b. Shareholders probably have their fingers crossed that it can grow its way to profits.
So How Risky Is Guangzhou Automobile Group?
Although Guangzhou Automobile Group had an earnings before interest and tax (EBIT) loss over the last twelve months, it made a statutory profit of CN¥8.2b. So when you consider it has net cash, along with the statutory profit, the stock probably isn't as risky as it might seem, at least in the short term. The good news for Guangzhou Automobile Group shareholders is that its revenue growth is strong, making it easier to raise capital if need be. But we still think it's somewhat risky. 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. To that end, you should learn about the 2 warning signs we've spotted with Guangzhou Automobile Group (including 1 which can't be ignored) .
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.
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