Chongqing Machinery & Electric (HKG:2722) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, '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. Importantly, Chongqing Machinery & Electric Co., Ltd. (HKG:2722) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Chongqing Machinery & Electric

What Is Chongqing Machinery & Electric's Net Debt?

The image below, which you can click on for greater detail, shows that Chongqing Machinery & Electric had debt of CN¥2.92b at the end of December 2020, a reduction from CN¥3.06b over a year. However, because it has a cash reserve of CN¥1.74b, its net debt is less, at about CN¥1.18b.

How Healthy Is Chongqing Machinery & Electric's Balance Sheet?

According to the last reported balance sheet, Chongqing Machinery & Electric had liabilities of CN¥7.09b due within 12 months, and liabilities of CN¥2.05b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.74b as well as receivables valued at CN¥6.43b due within 12 months. So it has liabilities totalling CN¥979.9m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Chongqing Machinery & Electric is worth CN¥1.71b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Chongqing Machinery & Electric's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We also note that Chongqing Machinery & Electric improved its EBIT from a last year's loss to a positive CN¥215m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Chongqing Machinery & Electric 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, Chongqing Machinery & Electric's free cash flow amounted to 33% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Chongqing Machinery & Electric's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Chongqing Machinery & Electric 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. 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. For example, we've discovered 3 warning signs for Chongqing Machinery & Electric (1 is concerning!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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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