Guangzhou Automobile Group (HKG: 2238) risky use of debt?

Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that 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. Like many other companies Guangzhou Automobile Group Co., Ltd. (HKG: 2238) uses debt. But the most important question is: what risk does this debt create?

When is debt dangerous?

Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.

See our latest analysis for Guangzhou Automobile Group

What is the debt of the Guangzhou automobile group?

The image below, which you can click for more details, shows that in March 2021, Guangzhou Automobile Group had a debt of CN 14.9 billion, compared to CN 11.6 billion in a year. But it also has CNN 22.2 billion in cash to compensate for this, which means it has a net cash position of CNN 7.38 billion.

SEHK: 2238 History of debt to equity July 14, 2021

A look at the responsibilities of the Guangzhou automotive group

Zooming in on the latest balance sheet data, we can see that Guangzhou Automobile Group had CN 36.7 billion in liabilities due within 12 months and CN in liabilities of 15.2 billion beyond. In compensation for these obligations, it had cash of CN 22.2 billion as well as receivables valued at CN 11.3 billion at 12 months. Its liabilities therefore total CN 18.3 billion more than the combination of its cash and short-term receivables.

Of course, Guangzhou Automobile Group has a titanic market cap of CN ¥ 134.2b, so these liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet as it can change over time. Despite its notable liabilities, Guangzhou Automobile Group has a net cash flow, so it is fair to say that it does not have a heavy debt load! When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Guangzhou Automobile Group can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Last year, Guangzhou Automobile Group was not profitable in EBIT level, but managed to increase its turnover by 22%, to CN ¥ 68b. The shareholders are probably keeping their fingers crossed that this could generate a profit.

What is the risk level of the Guangzhou automotive group?

Although Guangzhou Automobile Group recorded a loss of profit before interest and taxes (EBIT) in the past twelve months, it made a statutory profit of 8.2 billion yen. So when you consider that it has net cash, as well as statutory profit, the stock is probably not as risky as it looks, at least in the short term. The good news for Guangzhou Automobile Group shareholders is that its revenue growth is strong, making it easier to raise capital when needed. But we still think it’s a bit risky. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. To this end, you should inquire about the 2 warning signs we spotted with Guangzhou Automobile Group (including 1 which cannot be ignored).

At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.

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