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 note that China Yongda Automobiles Services Holdings Limited (HKG:3669) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Yongda Automobiles Services Holdings

How Much Debt Does China Yongda Automobiles Services Holdings Carry?

As you can see below, China Yongda Automobiles Services Holdings had CN¥5.05b of debt at June 2022, down from CN¥6.88b a year prior. On the flip side, it has CN¥3.69b in cash leading to net debt of about CN¥1.36b.

How Strong Is China Yongda Automobiles Services Holdings' Balance Sheet?

We can see from the most recent balance sheet that China Yongda Automobiles Services Holdings had liabilities of CN¥12.9b falling due within a year, and liabilities of CN¥3.84b due beyond that. Offsetting these obligations, it had cash of CN¥3.69b as well as receivables valued at CN¥3.35b due within 12 months. So its liabilities total CN¥9.68b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CN¥7.52b, we think shareholders really should watch China Yongda Automobiles Services Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

With net debt sitting at just 0.34 times EBITDA, China Yongda Automobiles Services Holdings is arguably pretty conservatively geared. And it boasts interest cover of 9.1 times, which is more than adequate. But the other side of the story is that China Yongda Automobiles Services Holdings saw its EBIT decline by 5.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Yongda Automobiles Services Holdings 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, China Yongda Automobiles Services Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

While China Yongda Automobiles Services Holdings's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. We think that China Yongda Automobiles Services Holdings's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that China Yongda Automobiles Services Holdings is showing 1 warning sign in our investment analysis , 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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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.