Huazhong In-Vehicle Holdings (HKG: 6830) takes risks with its use of debt
Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We note that Huazhong In-Vehicle Holdings Company Limited (HKG: 6830) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
When Is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we look at debt levels, we first consider both liquidity and debt levels.
Check out our latest review for Huazhong In-Vehicle Holdings
What is the debt of Huazhong In-Vehicle Holdings?
You can click on the graph below for historical figures, but it shows that Huazhong In-Vehicle Holdings had a debt of CN 820.3 million in June 2021, compared to CN 925.6 million a year earlier. However, since it has a cash reserve of CNN 120.9 million, its net debt is less, at around CNN 699.4 million.
How strong is Huazhong In-Vehicle Holdings’ balance sheet?
According to the latest published balance sheet, Huazhong In-Vehicle Holdings had liabilities of 1.91 billion yen due within 12 months and commitments of 218.9 million yen due beyond 12 months. On the other hand, he had a cash position of CN 120.9 million and CN 824.1 million of receivables due within one year. It therefore has liabilities totaling CN 1.18 billion more than its combined cash and short-term receivables.
Of course, Huazhong In-Vehicle Holdings has a market cap of CN ¥ 6.32b, so these liabilities are probably manageable. Having said that, it is clear that we must continue to monitor his record lest it get worse.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Huazhong In-Vehicle Holdings has a debt to EBITDA ratio of 3.2 and its EBIT covered interest expense 3.8 times. This suggests that while debt levels are significant, we would stop calling them problematic. The good news is that Huazhong In-Vehicle Holdings has increased its EBIT by 41% over the past twelve months. Like a mother’s loving embrace of a newborn, this type of growth builds resilience, putting the business in a stronger position to manage debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is the profits of Huazhong In-Vehicle Holdings that will influence the balance sheet in the future. So if you want to know more about its profits, it may be worth checking out this chart of its long term profit trend.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. In the past three years, Huazhong In-Vehicle Holdings has spent a lot of money. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
Neither Huazhong In-Vehicle Holdings’ ability to convert EBIT to free cash flow nor its interest coverage gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story and suggests some resilience. Looking at all of the angles mentioned above, it seems to us that Huazhong In-Vehicle Holdings is a somewhat risky investment due to its debt. Not all risks are bad, as they can increase stock price returns if they are profitable, but this risk of leverage is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. Concrete example: we have spotted 3 warning signs for Huazhong In-Vehicle Holdings you need to be aware of it, and one of them is a bit of a concern.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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