Huazhong In-Vehicle Holdings (HKG:6830) Takes On Some Risk With Its Use Of Debt

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Huazhong In-Vehicle Holdings Company Limited (HKG:6830) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Huazhong In-Vehicle Holdings

What Is Huazhong In-Vehicle Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Huazhong In-Vehicle Holdings had CN¥820.3m of debt in June 2021, down from CN¥925.6m, one year before. However, because it has a cash reserve of CN¥120.9m, its net debt is less, at about CN¥699.4m.

How Strong Is Huazhong In-Vehicle Holdings' Balance Sheet?

According to the last reported balance sheet, Huazhong In-Vehicle Holdings had liabilities of CN¥1.91b due within 12 months, and liabilities of CN¥218.9m due beyond 12 months. On the other hand, it had cash of CN¥120.9m and CN¥824.1m worth of receivables due within a year. So it has liabilities totalling CN¥1.18b more than its cash and near-term receivables, combined.

Of course, Huazhong In-Vehicle Holdings has a market capitalization of CN¥6.32b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Huazhong In-Vehicle Holdings has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Huazhong In-Vehicle Holdings grew its EBIT a smooth 41% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Huazhong In-Vehicle Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Huazhong In-Vehicle Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Huazhong In-Vehicle Holdings's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Huazhong In-Vehicle Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Case in point: We've spotted 3 warning signs for Huazhong In-Vehicle Holdings you should be aware of, and 1 of them is a bit concerning.

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. 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.
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