Is Xingfa Aluminum Holdings (HKG: 98) a risky investment?

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Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We can see that Xingfa Aluminum Holdings Limited (HKG: 98) uses debt in its business. But the most important question is: what risk does this debt create?

What risk does debt entail?

Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.

See our latest analysis for Xingfa Aluminum Holdings

What is the debt of Xingfa Aluminum Holdings?

As you can see below, at the end of June 2021, Xingfa Aluminum Holdings was in debt of CN 3.44 billion, up from CN’s 1.60 billion a year ago. Click on the image for more details. However, he also had CN 1.48 billion in cash, so his net debt was CN 1.96 billion.

SEHK: 98 History of debt to equity October 5, 2021

How healthy is Xingfa Aluminum Holdings’ balance sheet?

According to the latest published balance sheet, Xingfa Aluminum Holdings had CN 4.98 billion in debts due within 12 months and CN 832.5 million in debts due beyond 12 months. In return, he had CN 1.48 billion in cash and CN 4.05 billion in receivables due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by 283.1 million yen.

Considering that Xingfa Aluminum Holdings has a market cap of CN ¥ 3.31b, it is hard to believe that these liabilities pose a significant threat. However, we think it’s worth keeping an eye on the strength of its balance sheet as it can change over time.

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.

Xingfa Aluminum Holdings has a low net debt to EBITDA ratio of just 1.4. And its EBIT covers its interest costs 50.9 times more. So we’re pretty relaxed about its ultra-conservative use of debt. On top of that, we are happy to report that Xingfa Aluminum Holdings has increased its EBIT by 34%, reducing the specter of future debt repayments. The balance sheet is clearly the area you need to focus on when analyzing debt. But you can’t look at debt in isolation; since Xingfa Aluminum Holdings will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.

But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Xingfa Aluminum Holdings has recorded free cash flow of 74% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.

Our point of view

The good news is that Xingfa Aluminum Holdings’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the start of good news as its EBIT growth rate is also very encouraging. Considering this range of factors, it seems to us that Xingfa Aluminum Holdings is fairly conservative with its debt, and the risks appear to be well managed. We are therefore not worried about the use of a small leverage on the balance sheet. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. We have identified 3 warning signs with Xingfa Aluminum Holdings, and understanding them should be part of your investment process.

Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.

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