Here's Why AAC Technologies Holdings (HKG:2018) Can Manage Its Debt Responsibly

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Simply Wall St

Wed, Sep 25, 2019, 7:30 PM

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. 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. Importantly, AAC Technologies Holdings Inc. (HKG:2018) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for AAC Technologies Holdings

How Much Debt Does AAC Technologies Holdings Carry?

The chart below, which you can click on for greater detail, shows that AAC Technologies Holdings had CN¥6.03b in debt in June 2019; about the same as the year before. However, it does have CN¥3.24b in cash offsetting this, leading to net debt of about CN¥2.80b.

SEHK:2018 Historical Debt, September 26th 2019

How Healthy Is AAC Technologies Holdings's Balance Sheet?

According to the last reported balance sheet, AAC Technologies Holdings had liabilities of CN¥6.67b due within 12 months, and liabilities of CN¥3.98b due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.24b as well as receivables valued at CN¥4.34b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.07b.

Since publicly traded AAC Technologies Holdings shares are worth a total of CN¥47.4b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

AAC Technologies Holdings has a low net debt to EBITDA ratio of only 0.55. And its EBIT covers its interest expense a whopping 17.2 times over. So we're pretty relaxed about its super-conservative use of debt. In fact AAC Technologies Holdings's saving grace is its low debt levels, because its EBIT has tanked 43% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AAC Technologies Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, AAC Technologies Holdings recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

AAC Technologies Holdings's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about AAC Technologies Holdings'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. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that AAC Technologies Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.

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