We Think Yincheng International Holding (HKG:1902) Is Taking Some Risk With Its Debt

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.' 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. We note that Yincheng International Holding Co., Ltd. (HKG:1902) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Yincheng International Holding

What Is Yincheng International Holding's Net Debt?

The image below, which you can click on for greater detail, shows that Yincheng International Holding had debt of CN¥13.6b at the end of December 2021, a reduction from CN¥14.4b over a year. However, it does have CN¥3.31b in cash offsetting this, leading to net debt of about CN¥10.3b.

How Healthy Is Yincheng International Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Yincheng International Holding had liabilities of CN¥29.0b due within 12 months and liabilities of CN¥9.03b due beyond that. Offsetting these obligations, it had cash of CN¥3.31b as well as receivables valued at CN¥8.10b due within 12 months. So it has liabilities totalling CN¥26.6b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥3.29b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Yincheng International Holding 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 10.0, it's fair to say Yincheng International Holding does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.5 times, suggesting it can responsibly service its obligations. It is well worth noting that Yincheng International Holding's EBIT shot up like bamboo after rain, gaining 46% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Yincheng International Holding will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Yincheng International Holding actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

While Yincheng International Holding's level of total liabilities has us nervous. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Yincheng International Holding's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Yincheng International Holding has 3 warning signs (and 1 which is significant) we think you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.