Is Chongqing Machinery & Electric (HKG:2722) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Chongqing Machinery & Electric Co., Ltd. (HKG:2722) does carry debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Chongqing Machinery & Electric

What Is Chongqing Machinery & Electric's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Chongqing Machinery & Electric had CN¥3.70b of debt, an increase on CN¥3.25b, over one year. However, it also had CN¥2.29b in cash, and so its net debt is CN¥1.41b.

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

We can see from the most recent balance sheet that Chongqing Machinery & Electric had liabilities of CN¥6.96b falling due within a year, and liabilities of CN¥2.43b due beyond that. Offsetting this, it had CN¥2.29b in cash and CN¥5.81b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.30b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥1.47b, so it does suggest shareholders should keep an eye on Chongqing Machinery & Electric's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. 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.

In the last year Chongqing Machinery & Electric wasn't profitable at an EBIT level, but managed to grow its revenue by 18%, to CN¥5.8b. We usually like to see faster growth from unprofitable companies, but each to their own.

Caveat Emptor

Importantly, Chongqing Machinery & Electric had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable CN¥177m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Surprisingly, we note that it actually reported positive free cash flow of CN¥4.7m and a profit of CN¥130m. So one might argue that there's still a chance it can get things on the right track. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Chongqing Machinery & Electric (at least 2 which shouldn't be ignored) , 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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