Does AAC Technologies Holdings (HKG:2018) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, AAC Technologies Holdings Inc. (HKG:2018) does carry 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for AAC Technologies Holdings

How Much Debt Does AAC Technologies Holdings Carry?

As you can see below, at the end of December 2021, AAC Technologies Holdings had CN¥9.81b of debt, up from CN¥8.43b a year ago. Click the image for more detail. However, it also had CN¥6.05b in cash, and so its net debt is CN¥3.76b.

How Healthy Is AAC Technologies Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that AAC Technologies Holdings had liabilities of CN¥9.67b due within 12 months and liabilities of CN¥9.85b due beyond that. Offsetting these obligations, it had cash of CN¥6.05b as well as receivables valued at CN¥5.66b due within 12 months. So it has liabilities totalling CN¥7.81b more than its cash and near-term receivables, combined.

This deficit isn't so bad because AAC Technologies Holdings is worth CN¥18.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Looking at its net debt to EBITDA of 0.99 and interest cover of 5.0 times, it seems to us that AAC Technologies Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. One way AAC Technologies Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 10%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AAC Technologies Holdings 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 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, AAC Technologies Holdings reported free cash flow worth 5.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

AAC Technologies Holdings's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. We think that AAC Technologies Holdings'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. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for AAC Technologies Holdings you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.