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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that China Yongda Automobiles Services Holdings Limited (HKG:3669) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for China Yongda Automobiles Services Holdings
What Is China Yongda Automobiles Services Holdings's Net Debt?
As you can see below, China Yongda Automobiles Services Holdings had CN¥12.7b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had CN¥3.18b in cash, and so its net debt is CN¥9.56b.
How Healthy Is China Yongda Automobiles Services Holdings's Balance Sheet?
The latest balance sheet data shows that China Yongda Automobiles Services Holdings had liabilities of CN¥17.9b due within a year, and liabilities of CN¥4.49b falling due after that. On the other hand, it had cash of CN¥3.18b and CN¥6.57b worth of receivables due within a year. So its liabilities total CN¥12.6b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's CN¥11.1b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.