Here's Why Huazhong In-Vehicle Holdings (HKG:6830) Is Weighed Down By Its Debt Load
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. 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 Huazhong In-Vehicle Holdings Company Limited (HKG:6830) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Huazhong In-Vehicle Holdings
What Is Huazhong In-Vehicle Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Huazhong In-Vehicle Holdings had debt of CN¥928.1m, up from CN¥791.1m in one year. However, because it has a cash reserve of CN¥90.1m, its net debt is less, at about CN¥838.0m.
How Healthy Is Huazhong In-Vehicle Holdings's Balance Sheet?
According to the last reported balance sheet, Huazhong In-Vehicle Holdings had liabilities of CN¥2.00b due within 12 months, and liabilities of CN¥247.3m due beyond 12 months. On the other hand, it had cash of CN¥90.1m and CN¥859.1m worth of receivables due within a year. So its liabilities total CN¥1.29b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥1.69b, so it does suggest shareholders should keep an eye on Huazhong In-Vehicle Holdings's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Huazhong In-Vehicle Holdings has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 3.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Huazhong In-Vehicle Holdings's EBIT was down 36% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Huazhong In-Vehicle Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Huazhong In-Vehicle Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
On the face of it, Huazhong In-Vehicle Holdings's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. Overall, it seems to us that Huazhong In-Vehicle Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given the risks around Huazhong In-Vehicle Holdings's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
