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.' 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 Yingkou Jinchen Machinery Co., Ltd. (SHSE:603396) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Yingkou Jinchen Machinery

What Is Yingkou Jinchen Machinery's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Yingkou Jinchen Machinery had CN¥551.4m of debt, an increase on CN¥370.0m, over one year. However, because it has a cash reserve of CN¥414.6m, its net debt is less, at about CN¥136.8m.

How Healthy Is Yingkou Jinchen Machinery's Balance Sheet?

According to the last reported balance sheet, Yingkou Jinchen Machinery had liabilities of CN¥3.65b due within 12 months, and liabilities of CN¥115.1m due beyond 12 months. On the other hand, it had cash of CN¥414.6m and CN¥1.47b worth of receivables due within a year. So its liabilities total CN¥1.88b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Yingkou Jinchen Machinery is worth CN¥5.91b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Yingkou Jinchen Machinery has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 47.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Yingkou Jinchen Machinery grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Yingkou Jinchen Machinery 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Yingkou Jinchen Machinery burned a lot of cash. 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 Yingkou Jinchen Machinery 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 Yingkou Jinchen Machinery 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Yingkou Jinchen Machinery (1 is a bit concerning) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.