Is Weichai Power (HKG:2338) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Weichai Power Co., Ltd. (HKG:2338) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Weichai Power

What Is Weichai Power's Net Debt?

The image below, which you can click on for greater detail, shows that Weichai Power had debt of CN¥29.1b at the end of March 2022, a reduction from CN¥31.2b over a year. But it also has CN¥74.0b in cash to offset that, meaning it has CN¥44.9b net cash.

A Look At Weichai Power's Liabilities

Zooming in on the latest balance sheet data, we can see that Weichai Power had liabilities of CN¥115.5b due within 12 months and liabilities of CN¥56.6b due beyond that. Offsetting this, it had CN¥74.0b in cash and CN¥49.3b in receivables that were due within 12 months. So its liabilities total CN¥48.7b more than the combination of its cash and short-term receivables.

Weichai Power has a very large market capitalization of CN¥108.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Weichai Power also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Weichai Power if management cannot prevent a repeat of the 38% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Weichai Power's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Weichai Power has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Weichai Power actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

Although Weichai Power's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥44.9b. And it impressed us with free cash flow of CN¥6.0b, being 117% of its EBIT. So we are not troubled with Weichai Power's debt use. 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. We've identified 1 warning sign with Weichai Power , 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. 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.