Does Yue Yuen Industrial (Holdings) (HKG:551) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Yue Yuen Industrial (Holdings) Limited (HKG:551) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Yue Yuen Industrial (Holdings)

How Much Debt Does Yue Yuen Industrial (Holdings) Carry?

As you can see below, Yue Yuen Industrial (Holdings) had US$2.42b of debt at June 2021, down from US$2.69b a year prior. However, it also had US$1.08b in cash, and so its net debt is US$1.34b.

How Healthy Is Yue Yuen Industrial (Holdings)'s Balance Sheet?

The latest balance sheet data shows that Yue Yuen Industrial (Holdings) had liabilities of US$2.22b due within a year, and liabilities of US$1.81b falling due after that. Offsetting these obligations, it had cash of US$1.08b as well as receivables valued at US$1.70b due within 12 months. So it has liabilities totalling US$1.24b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Yue Yuen Industrial (Holdings) is worth US$2.78b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Yue Yuen Industrial (Holdings) has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 3.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, the silver lining was that Yue Yuen Industrial (Holdings) achieved a positive EBIT of US$136m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Yue Yuen Industrial (Holdings)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Yue Yuen Industrial (Holdings) actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

When it comes to the balance sheet, the standout positive for Yue Yuen Industrial (Holdings) was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For example, its interest cover makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Yue Yuen Industrial (Holdings)'s debt levels. 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Yue Yuen Industrial (Holdings) has 1 warning sign we think you should be aware of.

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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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.