Here's Why AAC Technologies Holdings (HKG:2018) Can Manage Its Debt Responsibly

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.' 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 can see that AAC Technologies Holdings Inc. (HKG:2018) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for AAC Technologies Holdings

What Is AAC Technologies Holdings's Debt?

As you can see below, at the end of June 2021, AAC Technologies Holdings had CN¥9.90b of debt, up from CN¥8.72b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥7.80b, its net debt is less, at about CN¥2.10b.

How Strong Is AAC Technologies Holdings' Balance Sheet?

According to the last reported balance sheet, AAC Technologies Holdings had liabilities of CN¥8.98b due within 12 months, and liabilities of CN¥10.1b due beyond 12 months. Offsetting this, it had CN¥7.80b in cash and CN¥5.78b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.54b.

Since publicly traded AAC Technologies Holdings shares are worth a total of CN¥42.8b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

While AAC Technologies Holdings's low debt to EBITDA ratio of 0.48 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.1 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. While AAC Technologies Holdings doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 AAC Technologies Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, AAC Technologies Holdings reported free cash flow worth 10% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for AAC Technologies Holdings was the fact that it seems able handle its debt, based on its EBITDA, confidently. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about AAC Technologies Holdings's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For instance, we've identified 2 warning signs for AAC Technologies Holdings that you should be aware of.

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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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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