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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Shanghai Daimay Automotive Interior Co., Ltd (SHSE:603730) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
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How Much Debt Does Shanghai Daimay Automotive Interior Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2023 Shanghai Daimay Automotive Interior had CN¥1.55b of debt, an increase on CN¥300.0m, over one year. However, because it has a cash reserve of CN¥1.26b, its net debt is less, at about CN¥290.8m.
A Look At Shanghai Daimay Automotive Interior’s Liabilities
We can see from the most recent balance sheet that Shanghai Daimay Automotive Interior had liabilities of CN¥1.72b falling due within a year, and liabilities of CN¥1.13b due beyond that. On the other hand, it had cash of CN¥1.26b and CN¥1.32b worth of receivables due within a year. So it has liabilities totalling CN¥275.4m more than its cash and near-term receivables, combined.
Having regard to Shanghai Daimay Automotive Interior’s size, it seems that its liquid assets are well balanced with its total liabilities. So while it’s hard to imagine that the CN¥15.7b company is struggling for cash, we still think it’s worth monitoring its balance sheet.
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.
Shanghai Daimay Automotive Interior has a low net debt to EBITDA ratio of only 0.37. And its EBIT easily covers its interest expense, being 34.0 times the size. So we’re pretty relaxed about its super-conservative use of debt. On top of that, Shanghai Daimay Automotive Interior grew its EBIT by 57% 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 it is future earnings, more than anything, that will determine Shanghai Daimay Automotive Interior’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shanghai Daimay Automotive Interior reported free cash flow worth 4.3% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
The good news is that Shanghai Daimay Automotive Interior’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. When we consider the range of factors above, it looks like Shanghai Daimay Automotive Interior is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. We’ve identified 1 warning sign with Shanghai Daimay Automotive Interior , and understanding them should be part of your investment process.
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.