Is Yue Yuen Industrial (Holdings) (HKG:551) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Yue Yuen Industrial (Holdings) Limited (HKG:551) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Yue Yuen Industrial (Holdings)

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

You can click the graphic below for the historical numbers, but it shows that Yue Yuen Industrial (Holdings) had US$1.43b of debt in December 2022, down from US$1.73b, one year before. However, because it has a cash reserve of US$1.08b, its net debt is less, at about US$352.5m.

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

According to the last reported balance sheet, Yue Yuen Industrial (Holdings) had liabilities of US$2.00b due within 12 months, and liabilities of US$1.29b due beyond 12 months. Offsetting these obligations, it had cash of US$1.08b as well as receivables valued at US$1.44b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$774.7m.

Yue Yuen Industrial (Holdings) has a market capitalization of US$2.24b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Yue Yuen Industrial (Holdings) has net debt of just 0.38 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.0 times the interest expense over the last year. Better yet, Yue Yuen Industrial (Holdings) grew its EBIT by 1,479% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent two years, Yue Yuen Industrial (Holdings) recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Yue Yuen Industrial (Holdings)'s demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Yue Yuen Industrial (Holdings) can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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, we've discovered 1 warning sign for Yue Yuen Industrial (Holdings) that you should be aware of before investing here.

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.