Yangtze Optical Fibre And Cable Limited (HKG:6869) Seems To Use Debt Quite Sensibly

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. We can see that Yangtze Optical Fibre And Cable Joint Stock Limited Company (HKG:6869) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Yangtze Optical Fibre And Cable Limited

How Much Debt Does Yangtze Optical Fibre And Cable Limited Carry?

The image below, which you can click on for greater detail, shows that at March 2021 Yangtze Optical Fibre And Cable Limited had debt of CN¥2.49b, up from CN¥1.44b in one year. However, it also had CN¥2.31b in cash, and so its net debt is CN¥178.2m.

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

According to the last reported balance sheet, Yangtze Optical Fibre And Cable Limited had liabilities of CN¥4.59b due within 12 months, and liabilities of CN¥2.30b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.31b as well as receivables valued at CN¥4.87b due within 12 months. So it actually has CN¥298.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Yangtze Optical Fibre And Cable Limited could probably pay off its debt with ease, as its balance sheet is far from stretched. Carrying virtually no net debt, Yangtze Optical Fibre And Cable Limited has a very light debt load indeed.

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).

Yangtze Optical Fibre And Cable Limited has a low debt to EBITDA ratio of only 0.23. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. Fortunately, Yangtze Optical Fibre And Cable Limited grew its EBIT by 2.3% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Yangtze Optical Fibre And Cable Limited 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.

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. Over the last three years, Yangtze Optical Fibre And Cable Limited saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen Yangtze Optical Fibre And Cable Limited is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Yangtze Optical Fibre And Cable Limited is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 2 warning signs for Yangtze Optical Fibre And Cable Limited you should be aware of.

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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