Is Xingye Alloy Materials Group (HKG:505) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Xingye Alloy Materials Group Limited (HKG:505) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Xingye Alloy Materials Group

What Is Xingye Alloy Materials Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Xingye Alloy Materials Group had CN¥917.2m of debt, an increase on CN¥845.9m, over one year. On the flip side, it has CN¥366.5m in cash leading to net debt of about CN¥550.7m.

A Look At Xingye Alloy Materials Group's Liabilities

According to the last reported balance sheet, Xingye Alloy Materials Group had liabilities of CN¥1.59b due within 12 months, and liabilities of CN¥132.0m due beyond 12 months. On the other hand, it had cash of CN¥366.5m and CN¥384.2m worth of receivables due within a year. So it has liabilities totalling CN¥973.5m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥794.5m, we think shareholders really should watch Xingye Alloy Materials Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Xingye Alloy Materials Group's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 12.0 times, makes us even more comfortable. We note that Xingye Alloy Materials Group grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Xingye Alloy Materials Group 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 that EBIT is backed by free cash flow. Looking at the most recent three years, Xingye Alloy Materials Group recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We feel some trepidation about Xingye Alloy Materials Group's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Xingye Alloy Materials Group's debt does make it a bit risky, after considering the aforementioned data points together. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Xingye Alloy Materials Group you should be aware of.

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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