China Weaving Materials Holdings (HKG:3778) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, China Weaving Materials Holdings Limited (HKG:3778) does carry debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China Weaving Materials Holdings

What Is China Weaving Materials Holdings's Debt?

As you can see below, at the end of December 2021, China Weaving Materials Holdings had CN¥550.5m of debt, up from CN¥491.4m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥283.0m, its net debt is less, at about CN¥267.4m.

A Look At China Weaving Materials Holdings' Liabilities

The latest balance sheet data shows that China Weaving Materials Holdings had liabilities of CN¥815.4m due within a year, and liabilities of CN¥93.0m falling due after that. Offsetting this, it had CN¥283.0m in cash and CN¥16.2m in receivables that were due within 12 months. So it has liabilities totalling CN¥609.2m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥461.8m, we think shareholders really should watch China Weaving Materials Holdings'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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Weaving Materials Holdings's net debt is only 0.80 times its EBITDA. And its EBIT easily covers its interest expense, being 13.6 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that China Weaving Materials Holdings grew its EBIT by 180% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is China Weaving Materials Holdings'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Weaving Materials Holdings produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both China Weaving Materials Holdings's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about China Weaving Materials Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for China Weaving Materials Holdings that you should be aware of before investing here.

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.