We Think Yongsheng Advanced Materials (HKG:3608) Is Taking Some Risk With Its 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 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 Yongsheng Advanced Materials Company Limited (HKG:3608) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Yongsheng Advanced Materials

How Much Debt Does Yongsheng Advanced Materials Carry?

As you can see below, Yongsheng Advanced Materials had CN¥216.1m of debt at December 2022, down from CN¥236.6m a year prior. However, it also had CN¥177.8m in cash, and so its net debt is CN¥38.3m.

A Look At Yongsheng Advanced Materials' Liabilities

The latest balance sheet data shows that Yongsheng Advanced Materials had liabilities of CN¥180.1m due within a year, and liabilities of CN¥165.9m falling due after that. On the other hand, it had cash of CN¥177.8m and CN¥220.8m worth of receivables due within a year. So it actually has CN¥52.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Yongsheng Advanced Materials could probably pay off its debt with ease, as its balance sheet is far from stretched.

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 net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 38.3 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Yongsheng Advanced Materials's EBIT dived 18%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Yongsheng Advanced Materials burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Yongsheng Advanced Materials's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Yongsheng Advanced Materials is a somewhat risky investment as a result of its debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Yongsheng Advanced Materials (including 1 which is significant) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.