Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. Importantly, China Tianrui Automotive Interiors Co., LTD (HKG:6162) does carry debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for China Tianrui Automotive Interiors
How Much Debt Does China Tianrui Automotive Interiors Carry?
You can click the graphic below for the historical numbers, but it shows that China Tianrui Automotive Interiors had CN¥98.7m of debt in June 2021, down from CN¥108.0m, one year before. However, it does have CN¥26.2m in cash offsetting this, leading to net debt of about CN¥72.5m.
How Strong Is China Tianrui Automotive Interiors’ Balance Sheet?
According to the last reported balance sheet, China Tianrui Automotive Interiors had liabilities of CN¥262.4m due within 12 months, and liabilities of CN¥16.2m due beyond 12 months. Offsetting this, it had CN¥26.2m in cash and CN¥269.4m in receivables that were due within 12 months. So it actually has CN¥17.1m more liquid assets than total liabilities.
This short term liquidity is a sign that China Tianrui Automotive Interiors could probably pay off its debt with ease, as its balance sheet is far from stretched.
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).
Looking at its net debt to EBITDA of 0.88 and interest cover of 5.9 times, it seems to us that China Tianrui Automotive Interiors is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Unfortunately, China Tianrui Automotive Interiors saw its EBIT slide 3.1% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since China Tianrui Automotive Interiors 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, China Tianrui Automotive Interiors actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Based on what we’ve seen China Tianrui Automotive Interiors 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. In particular, we thought its net debt to EBITDA was a positive. Looking at all this data makes us feel a little cautious about China Tianrui Automotive Interiors’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. 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 example – China Tianrui Automotive Interiors has 4 warning signs we think you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.
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