China National Building Material (HKG:3323) Has A Somewhat Strained Balance Sheet

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. Importantly, China National Building Material Company Limited (HKG:3323) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China National Building Material

What Is China National Building Material's Debt?

As you can see below, China National Building Material had CN¥166.9b of debt at December 2021, down from CN¥177.4b a year prior. On the flip side, it has CN¥35.5b in cash leading to net debt of about CN¥131.3b.

How Strong Is China National Building Material's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China National Building Material had liabilities of CN¥182.9b due within 12 months and liabilities of CN¥101.0b due beyond that. Offsetting these obligations, it had cash of CN¥35.5b as well as receivables valued at CN¥89.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥159.2b.

The deficiency here weighs heavily on the CN¥71.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, China National Building Material would likely require a major re-capitalisation if it had to pay its creditors today.

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).

China National Building Material has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 13.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We saw China National Building Material grow its EBIT by 4.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China National Building Material'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, China National Building Material produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither China National Building Material's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think China National Building Material's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for China National Building Material that 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.