These 4 Measures Indicate That China Aerospace International Holdings (HKG:31) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that China Aerospace International Holdings Limited (HKG:31) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Aerospace International Holdings

How Much Debt Does China Aerospace International Holdings Carry?

As you can see below, China Aerospace International Holdings had HK$1.42b of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$1.42b in cash offsetting this, leading to net debt of about HK$2.92m.

How Strong Is China Aerospace International Holdings's Balance Sheet?

We can see from the most recent balance sheet that China Aerospace International Holdings had liabilities of HK$1.21b falling due within a year, and liabilities of HK$3.85b due beyond that. On the other hand, it had cash of HK$1.42b and HK$1.07b worth of receivables due within a year. So its liabilities total HK$2.58b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$1.47b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Aerospace International Holdings would likely require a major re-capitalisation if it had to pay its creditors today. China Aerospace International Holdings has a very little net debt but plenty of other liabilities weighing it down.

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 Aerospace International Holdings's debt of just 0.0053 times EBITDA is really very modest. And EBIT easily covered the interest expense 7.1 times over, lending force to that view. While China Aerospace International Holdings doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Aerospace International Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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 most recent three years, China Aerospace International Holdings recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

China Aerospace International Holdings's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its net debt to EBITDA was re-invigorating. Taking the abovementioned factors together we do think China Aerospace International Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - China Aerospace International Holdings has 2 warning signs (and 1 which is concerning) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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