Is First Tractor (HKG:38) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies First Tractor Company Limited (HKG:38) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

Check out our latest analysis for First Tractor

What Is First Tractor's Debt?

As you can see below, First Tractor had CN¥600.4m of debt at December 2021, down from CN¥1.24b a year prior. But on the other hand it also has CN¥4.28b in cash, leading to a CN¥3.68b net cash position.

How Healthy Is First Tractor's Balance Sheet?

According to the last reported balance sheet, First Tractor had liabilities of CN¥5.89b due within 12 months, and liabilities of CN¥466.2m due beyond 12 months. Offsetting these obligations, it had cash of CN¥4.28b as well as receivables valued at CN¥1.36b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥712.7m.

Given First Tractor has a market capitalization of CN¥7.86b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, First Tractor also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although First Tractor made a loss at the EBIT level, last year, it was also good to see that it generated CN¥340m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since First Tractor 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. First Tractor may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, First Tractor 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

While it is always sensible to look at a company's total liabilities, it is very reassuring that First Tractor has CN¥3.68b in net cash. And it impressed us with free cash flow of CN¥514m, being 151% of its EBIT. So is First Tractor's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with First Tractor , and understanding them should be part of your investment process.

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. 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.