These 4 Measures Indicate That Yongsheng Advanced Materials (HKG:3608) Is Using Debt Safely

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Yongsheng Advanced Materials Company Limited (HKG:3608) does carry debt. But the real question is whether this debt is making the company risky.

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

Check out our latest analysis for Yongsheng Advanced Materials

What Is Yongsheng Advanced Materials's Debt?

As you can see below, at the end of June 2021, Yongsheng Advanced Materials had CN¥204.3m of debt, up from CN¥140.0m a year ago. Click the image for more detail. However, it also had CN¥176.9m in cash, and so its net debt is CN¥27.4m.

How Strong Is Yongsheng Advanced Materials' Balance Sheet?

We can see from the most recent balance sheet that Yongsheng Advanced Materials had liabilities of CN¥159.7m falling due within a year, and liabilities of CN¥184.6m due beyond that. Offsetting these obligations, it had cash of CN¥176.9m as well as receivables valued at CN¥318.3m due within 12 months. So it can boast CN¥150.9m more liquid assets than total liabilities.

This excess liquidity suggests that Yongsheng Advanced Materials is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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.

Yongsheng Advanced Materials has a low debt to EBITDA ratio of only 0.42. 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. On the other hand, Yongsheng Advanced Materials saw its EBIT drop by 8.7% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is Yongsheng Advanced Materials's earnings that will influence how the balance sheet holds up in the future. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Yongsheng Advanced Materials generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Yongsheng Advanced Materials's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Zooming out, Yongsheng Advanced Materials seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. Be aware that Yongsheng Advanced Materials is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.

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.

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