Is China Tianrui Automotive Interiors (HKG:6162) A Risky Investment?

Warren Buffett famously said, '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. Importantly, China Tianrui Automotive Interiors Co., LTD (HKG:6162) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Tianrui Automotive Interiors

What Is China Tianrui Automotive Interiors's Debt?

The image below, which you can click on for greater detail, shows that China Tianrui Automotive Interiors had debt of CN¥98.7m at the end of June 2021, a reduction from CN¥108.0m over a year. However, it also had CN¥26.2m in cash, and so its net debt is CN¥72.5m.

How Strong Is China Tianrui Automotive Interiors' Balance Sheet?

We can see from the most recent balance sheet that China Tianrui Automotive Interiors had liabilities of CN¥262.4m falling due within a year, and liabilities of CN¥16.2m due beyond that. Offsetting this, it had CN¥26.2m in cash and CN¥274.9m in receivables that were due within 12 months. So it can boast CN¥22.5m more liquid assets than total liabilities.

This surplus suggests that China Tianrui Automotive Interiors has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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).

Looking at its net debt to EBITDA of 0.85 and interest cover of 5.9 times, it seems to us that China Tianrui Automotive Interiors is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Sadly, China Tianrui Automotive Interiors's EBIT actually dropped 3.0% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Tianrui Automotive Interiors will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, China Tianrui Automotive Interiors actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

China Tianrui Automotive Interiors's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its net debt to EBITDA was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about China Tianrui Automotive Interiors's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for China Tianrui Automotive Interiors you should know about.

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.