Is Yue Yuen Industrial (Holdings) (HKG:551) 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.' 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 more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Yue Yuen Industrial (Holdings)

What Is Yue Yuen Industrial (Holdings)'s Net Debt?

As you can see below, Yue Yuen Industrial (Holdings) had US$1.73b of debt at December 2021, down from US$1.89b a year prior. However, because it has a cash reserve of US$957.6m, its net debt is less, at about US$767.9m.

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

We can see from the most recent balance sheet that Yue Yuen Industrial (Holdings) had liabilities of US$2.47b falling due within a year, and liabilities of US$1.57b due beyond that. Offsetting this, it had US$957.6m in cash and US$1.50b in receivables that were due within 12 months. So it has liabilities totalling US$1.57b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$2.54b, so it does suggest shareholders should keep an eye on Yue Yuen Industrial (Holdings)'s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

While Yue Yuen Industrial (Holdings) has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 0.65. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Notably, Yue Yuen Industrial (Holdings) made a loss at the EBIT level, last year, but improved that to positive EBIT of US$34m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Yue Yuen Industrial (Holdings) can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by 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

Yue Yuen Industrial (Holdings)'s interest cover was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Yue Yuen Industrial (Holdings) 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.