China Yongda Automobiles Services Holdings (HKG:3669) Has A Somewhat Strained Balance Sheet

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 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 can see that China Yongda Automobiles Services Holdings Limited (HKG:3669) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Yongda Automobiles Services Holdings

What Is China Yongda Automobiles Services Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that China Yongda Automobiles Services Holdings had CN¥10.3b of debt in December 2020, down from CN¥12.9b, one year before. However, it also had CN¥3.84b in cash, and so its net debt is CN¥6.42b.

How Strong Is China Yongda Automobiles Services Holdings' Balance Sheet?

The latest balance sheet data shows that China Yongda Automobiles Services Holdings had liabilities of CN¥16.0b due within a year, and liabilities of CN¥6.34b falling due after that. Offsetting these obligations, it had cash of CN¥3.84b as well as receivables valued at CN¥6.46b due within 12 months. So it has liabilities totalling CN¥12.1b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since China Yongda Automobiles Services Holdings has a market capitalization of CN¥24.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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 Yongda Automobiles Services Holdings has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.2 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly China Yongda Automobiles Services Holdings's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. 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 China Yongda Automobiles Services 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, China Yongda Automobiles Services Holdings recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While China Yongda Automobiles Services Holdings's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at managing its debt, based on its EBITDA,. Taking the abovementioned factors together we do think China Yongda Automobiles Services Holdings's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 4 warning signs we've spotted with China Yongda Automobiles Services Holdings .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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