David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Yue Yuen Industrial (Holdings) Limited (HKG:551) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Yue Yuen Industrial (Holdings)'s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Yue Yuen Industrial (Holdings) had US$972.7m of debt in December 2023, down from US$1.43b, one year before. However, it does have US$948.1m in cash offsetting this, leading to net debt of about US$24.5m.
How Healthy Is Yue Yuen Industrial (Holdings)'s Balance Sheet?
According to the last reported balance sheet, Yue Yuen Industrial (Holdings) had liabilities of US$1.98b due within 12 months, and liabilities of US$663.5m due beyond 12 months. Offsetting these obligations, it had cash of US$948.1m as well as receivables valued at US$1.18b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$524.4m.
Since publicly traded Yue Yuen Industrial (Holdings) shares are worth a total of US$2.95b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Yue Yuen Industrial (Holdings) has virtually no net debt, so it's fair to say it does not have a heavy debt load!
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt at just 0.045 times EBITDA, it seems Yue Yuen Industrial (Holdings) only uses a little bit of leverage. But EBIT was only 5.5 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. Sadly, Yue Yuen Industrial (Holdings)'s EBIT actually dropped 6.0% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Yue Yuen Industrial (Holdings)'s ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Yue Yuen Industrial (Holdings) actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
Happily, Yue Yuen Industrial (Holdings)'s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Yue Yuen Industrial (Holdings) can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Yue Yuen Industrial (Holdings) that you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.