These 4 Measures Indicate That China MeiDong Auto Holdings (HKG:1268) Is Using Debt Reasonably Well

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.' 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 China MeiDong Auto Holdings Limited (HKG:1268) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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?

The image below, which you can click on for greater detail, shows that at June 2022 China MeiDong Auto Holdings had debt of CN¥4.10b, up from CN¥843.8m in one year. However, it also had CN¥3.50b in cash, and so its net debt is CN¥598.8m.

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¥7.37b falling due within a year, and liabilities of CN¥4.78b due beyond that. Offsetting these obligations, it had cash of CN¥3.50b as well as receivables valued at CN¥961.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.69b.

China MeiDong Auto Holdings has a market capitalization of CN¥18.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt sitting at just 0.33 times EBITDA, China MeiDong Auto Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.4 times the interest expense over the last year. The good news is that China MeiDong Auto Holdings has increased its EBIT by 4.8% over twelve months, which should ease any concerns about debt repayment. 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.

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. Over the last three years, China MeiDong Auto Holdings recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, China MeiDong Auto Holdings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Taking all this data into account, it seems to us that China MeiDong Auto Holdings takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for China MeiDong Auto Holdings you should know about.

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.