Is Xin Yuan Enterprises Group (HKG:1748) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Xin Yuan Enterprises Group Limited (HKG:1748) does carry debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Xin Yuan Enterprises Group

What Is Xin Yuan Enterprises Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Xin Yuan Enterprises Group had US$60.2m of debt, an increase on US$40.8m, over one year. However, it does have US$38.8m in cash offsetting this, leading to net debt of about US$21.4m.

How Strong Is Xin Yuan Enterprises Group's Balance Sheet?

According to the last reported balance sheet, Xin Yuan Enterprises Group had liabilities of US$33.0m due within 12 months, and liabilities of US$47.8m due beyond 12 months. On the other hand, it had cash of US$38.8m and US$660.0k worth of receivables due within a year. So it has liabilities totalling US$41.3m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Xin Yuan Enterprises Group is worth US$154.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Xin Yuan Enterprises Group's EBIT has low interest coverage of 2.1 times. So one way or the other, it's clear the debt levels are not trivial. Pleasingly, Xin Yuan Enterprises Group is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 129% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xin Yuan Enterprises Group will need earnings to service that debt. 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. Happily for any shareholders, Xin Yuan Enterprises Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Xin Yuan Enterprises Group's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. Taking all this data into account, it seems to us that Xin Yuan Enterprises Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. For instance, we've identified 3 warning signs for Xin Yuan Enterprises Group (1 makes us a bit uncomfortable) you should be aware of.

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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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.