Is China MeiDong Auto Holdings (HKG:1268) A Risky Investment?

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. As with many other companies China MeiDong Auto Holdings Limited (HKG:1268) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China MeiDong Auto Holdings

What Is China MeiDong Auto Holdings's Net Debt?

As you can see below, China MeiDong Auto Holdings had CN¥3.66b of debt at December 2023, down from CN¥4.19b a year prior. However, because it has a cash reserve of CN¥2.92b, its net debt is less, at about CN¥734.6m.

How Healthy Is China MeiDong Auto Holdings' Balance Sheet?

We can see from the most recent balance sheet that China MeiDong Auto Holdings had liabilities of CN¥4.45b falling due within a year, and liabilities of CN¥4.49b due beyond that. Offsetting this, it had CN¥2.92b in cash and CN¥1.26b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.75b.

Given this deficit is actually higher than the company's market capitalization of CN¥3.32b, we think shareholders really should watch China MeiDong Auto Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While China MeiDong Auto Holdings's low debt to EBITDA ratio of 0.73 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.1 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, China MeiDong Auto Holdings's EBIT fell a jaw-dropping 45% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China MeiDong Auto 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, China MeiDong Auto Holdings generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

On the face of it, China MeiDong Auto Holdings's level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that China MeiDong Auto Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example - China MeiDong Auto Holdings has 2 warning signs we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.