Is Yangtze Optical Fibre And Cable Limited (HKG:6869) A Risky Investment?

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. As with many other companies Yangtze Optical Fibre And Cable Joint Stock Limited Company (HKG:6869) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Yangtze Optical Fibre And Cable Limited

What Is Yangtze Optical Fibre And Cable Limited's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Yangtze Optical Fibre And Cable Limited had CN¥6.55b of debt, an increase on CN¥4.00b, over one year. However, it does have CN¥5.77b in cash offsetting this, leading to net debt of about CN¥782.6m.

A Look At Yangtze Optical Fibre And Cable Limited's Liabilities

Zooming in on the latest balance sheet data, we can see that Yangtze Optical Fibre And Cable Limited had liabilities of CN¥8.46b due within 12 months and liabilities of CN¥5.42b due beyond that. Offsetting these obligations, it had cash of CN¥5.77b as well as receivables valued at CN¥6.69b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.42b.

Of course, Yangtze Optical Fibre And Cable Limited has a market capitalization of CN¥21.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Yangtze Optical Fibre And Cable Limited has a low net debt to EBITDA ratio of only 0.50. And its EBIT covers its interest expense a whopping 3k times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Yangtze Optical Fibre And Cable Limited grew its EBIT by 227% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Yangtze Optical Fibre And Cable Limited'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Yangtze Optical Fibre And Cable Limited burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, Yangtze Optical Fibre And Cable Limited's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Yangtze Optical Fibre And Cable Limited can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Yangtze Optical Fibre And Cable Limited insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.