Here's Why China Weaving Materials Holdings (HKG:3778) Has A Meaningful Debt Burden

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that China Weaving Materials Holdings Limited (HKG:3778) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Weaving Materials Holdings

How Much Debt Does China Weaving Materials Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 China Weaving Materials Holdings had CN¥491.4m of debt, an increase on CN¥465.2m, over one year. However, because it has a cash reserve of CN¥184.6m, its net debt is less, at about CN¥306.8m.

A Look At China Weaving Materials Holdings' Liabilities

The latest balance sheet data shows that China Weaving Materials Holdings had liabilities of CN¥800.1m due within a year, and liabilities of CN¥79.2m falling due after that. Offsetting this, it had CN¥184.6m in cash and CN¥19.8m in receivables that were due within 12 months. So its liabilities total CN¥674.9m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥443.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Weaving Materials Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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 sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 3.5 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly, China Weaving Materials Holdings grew its EBIT by 67% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since China Weaving Materials Holdings 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Weaving Materials Holdings recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

While China Weaving Materials Holdings's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that China Weaving Materials Holdings 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. 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 3 warning signs with China Weaving Materials Holdings , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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