These 4 Measures Indicate That Wei Yuan Holdings (HKG:1343) Is Using Debt Safely

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Wei Yuan Holdings Limited (HKG:1343) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Wei Yuan Holdings

What Is Wei Yuan Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Wei Yuan Holdings had S$32.0m of debt in December 2022, down from S$39.5m, one year before. However, because it has a cash reserve of S$17.5m, its net debt is less, at about S$14.5m.

A Look At Wei Yuan Holdings' Liabilities

We can see from the most recent balance sheet that Wei Yuan Holdings had liabilities of S$51.1m falling due within a year, and liabilities of S$6.27m due beyond that. Offsetting this, it had S$17.5m in cash and S$59.0m in receivables that were due within 12 months. So it actually has S$19.1m more liquid assets than total liabilities.

This surplus liquidity suggests that Wei Yuan Holdings' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Wei Yuan Holdings has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.0 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It is well worth noting that Wei Yuan Holdings's EBIT shot up like bamboo after rain, gaining 54% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Wei Yuan Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Wei Yuan Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Wei Yuan Holdings's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. It looks Wei Yuan Holdings has no trouble standing on its own two feet, and it has no reason to fear its lenders. For investing nerds like us its balance sheet is almost charming. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Wei Yuan Holdings (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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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.