Anhui Conch Cement (HKG:914) Could Easily Take On More 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Anhui Conch Cement Company Limited (HKG:914) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Anhui Conch Cement

How Much Debt Does Anhui Conch Cement Carry?

The image below, which you can click on for greater detail, shows that Anhui Conch Cement had debt of CN¥10.1b at the end of September 2021, a reduction from CN¥11.9b over a year. However, it does have CN¥89.9b in cash offsetting this, leading to net cash of CN¥79.8b.

How Strong Is Anhui Conch Cement's Balance Sheet?

We can see from the most recent balance sheet that Anhui Conch Cement had liabilities of CN¥24.2b falling due within a year, and liabilities of CN¥8.58b due beyond that. On the other hand, it had cash of CN¥89.9b and CN¥14.5b worth of receivables due within a year. So it actually has CN¥71.5b more liquid assets than total liabilities.

This surplus liquidity suggests that Anhui Conch Cement's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, Anhui Conch Cement boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that Anhui Conch Cement saw its EBIT decline by 8.8% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Anhui Conch Cement'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Anhui Conch Cement may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Anhui Conch Cement produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Anhui Conch Cement has net cash of CN¥79.8b, as well as more liquid assets than liabilities. The cherry on top was that in converted 67% of that EBIT to free cash flow, bringing in CN¥19b. So we don't think Anhui Conch Cement's use of debt is risky. 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. We've identified 2 warning signs with Anhui Conch Cement (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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.