These 4 Measures Indicate That China Harmony Auto Holding (HKG:3836) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 China Harmony Auto Holding Limited (HKG:3836) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Harmony Auto Holding

What Is China Harmony Auto Holding's Debt?

As you can see below, at the end of June 2021, China Harmony Auto Holding had CN¥2.60b of debt, up from CN¥2.41b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.08b, its net debt is less, at about CN¥519.1m.

How Strong Is China Harmony Auto Holding's Balance Sheet?

The latest balance sheet data shows that China Harmony Auto Holding had liabilities of CN¥4.15b due within a year, and liabilities of CN¥803.5m falling due after that. Offsetting these obligations, it had cash of CN¥2.08b as well as receivables valued at CN¥342.3m due within 12 months. So its liabilities total CN¥2.53b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since China Harmony Auto Holding has a market capitalization of CN¥5.44b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Harmony Auto Holding has a low net debt to EBITDA ratio of only 0.43. And its EBIT easily covers its interest expense, being 13.0 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, China Harmony Auto Holding grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Harmony Auto Holding can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. In the last three years, China Harmony Auto Holding's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, China Harmony Auto Holding's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that China Harmony Auto Holding takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that China Harmony Auto Holding insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.
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