Is China Automobile New Retail (Holdings) (HKG:526) Using Too Much 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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China Automobile New Retail (Holdings) Limited (HKG:526) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Automobile New Retail (Holdings)

What Is China Automobile New Retail (Holdings)'s Debt?

As you can see below, at the end of March 2021, China Automobile New Retail (Holdings) had CN¥2.89b of debt, up from CN¥1.38b a year ago. Click the image for more detail. However, it does have CN¥413.0m in cash offsetting this, leading to net debt of about CN¥2.48b.

How Healthy Is China Automobile New Retail (Holdings)'s Balance Sheet?

According to the last reported balance sheet, China Automobile New Retail (Holdings) had liabilities of CN¥4.06b due within 12 months, and liabilities of CN¥946.4m due beyond 12 months. Offsetting this, it had CN¥413.0m in cash and CN¥860.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.73b.

This deficit casts a shadow over the CN¥321.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, China Automobile New Retail (Holdings) would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Automobile New Retail (Holdings) shareholders face the double whammy of a high net debt to EBITDA ratio (13.2), and fairly weak interest coverage, since EBIT is just 0.58 times the interest expense. This means we'd consider it to have a heavy debt load. However, it should be some comfort for shareholders to recall that China Automobile New Retail (Holdings) actually grew its EBIT by a hefty 105%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Automobile New Retail (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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, China Automobile New Retail (Holdings) actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, China Automobile New Retail (Holdings)'s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that China Automobile New Retail (Holdings)'s balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example China Automobile New Retail (Holdings) has 3 warning signs (and 2 which are significant) we think you should know about.

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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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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