Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We note that Weichai Power Co., Ltd. (HKG: 2338) has debt on its balance sheet. But does this debt worry shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Weichai Power’s net debt?
As you can see below, Weichai Power had CN 34.6 billion debt in June 2021, up from CN 39.3 billion the year before. But on the other hand, it also has CNN 82.3 billion in cash, which leads to a net cash position of CN 47.7 billion.
How strong is Weichai Power’s balance sheet?
The latest balance sheet data shows Weichai Power had CN 142.1 billion in liabilities maturing within one year, and CN 61.0 billion in liabilities maturing thereafter. In compensation for these obligations, it had cash of 82.3 billion NC as well as receivables valued at 70.7 billion NC due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by CN ¥ 50.1b.
This deficit is not that big of a deal as Weichai Power is worth a whopping CN ¥ 149.5 billion, and therefore could possibly raise enough capital to consolidate its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay your debt. Despite its notable liabilities, Weichai Power has a net cash flow, so it’s fair to say that it doesn’t have a heavy debt load!
Another good sign, Weichai Power was able to increase its EBIT by 22% in twelve months, thus facilitating the repayment of the debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Weichai Power’s ability to maintain a healthy balance sheet in the future. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay its debts with paper profits; he needs hard cash. While Weichai Power has net cash on its balance sheet, it’s still worth looking at its ability to convert earnings before interest and taxes (EBIT) into free cash flow, to help us understand how fast it’s building ( or erodes) this cash balance. Over the past three years, Weichai Power has actually generated more free cash flow than EBIT. There is nothing better than cash flow to stay in the good graces of your lenders.
While Weichai Power’s balance sheet is not particularly strong, due to total liabilities it is clearly positive to see that we have a net cash position of 47.7 billion yen. The icing on the cake was that he converted 128% of that EBIT into free cash flow, which brought in CN ¥ 21b. So is Weichai Power’s debt a risk? It does not seem to us. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 2 warning signs for Weichai Power which you should know before investing here.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
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