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

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Chongqing Machinery & Electric Co., Ltd. (HKG:2722) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Chongqing Machinery & Electric

What Is Chongqing Machinery & Electric's Net Debt?

As you can see below, at the end of June 2023, Chongqing Machinery & Electric had CN¥3.01b of debt, up from CN¥2.88b a year ago. Click the image for more detail. However, it does have CN¥2.68b in cash offsetting this, leading to net debt of about CN¥330.4m.

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

According to the last reported balance sheet, Chongqing Machinery & Electric had liabilities of CN¥7.58b due within 12 months, and liabilities of CN¥2.19b due beyond 12 months. Offsetting this, it had CN¥2.68b in cash and CN¥6.20b in receivables that were due within 12 months. So its liabilities total CN¥888.9m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Chongqing Machinery & Electric has a market capitalization of CN¥2.12b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chongqing Machinery & Electric has net debt of just 1.1 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. It was also good to see that despite losing money on the EBIT line last year, Chongqing Machinery & Electric turned things around in the last 12 months, delivering and EBIT of CN¥81m. 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 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Chongqing Machinery & Electric saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Chongqing Machinery & Electric's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Chongqing Machinery & Electric's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we've identified 3 warning signs for Chongqing Machinery & Electric (1 can't be ignored) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.