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. We can see that Shenzhen Megmeet Electrical Co., LTD (SZSE:002851) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Megmeet Electrical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shenzhen Megmeet Electrical had CN¥2.23b of debt, an increase on CN¥1.42b, over one year. On the flip side, it has CN¥1.78b in cash leading to net debt of about CN¥453.4m.

How Strong Is Shenzhen Megmeet Electrical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Megmeet Electrical had liabilities of CN¥4.45b due within 12 months and liabilities of CN¥1.49b due beyond that. Offsetting this, it had CN¥1.78b in cash and CN¥2.67b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.49b more than its cash and near-term receivables, combined.

Since publicly traded Shenzhen Megmeet Electrical shares are worth a total of CN¥11.9b, 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shenzhen Megmeet Electrical has a low net debt to EBITDA ratio of only 0.87. And its EBIT covers its interest expense a whopping 14.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Shenzhen Megmeet Electrical grew its EBIT by 11% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shenzhen Megmeet Electrical 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shenzhen Megmeet Electrical saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Based on what we've seen Shenzhen Megmeet Electrical 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 are dazzled with its interest cover. Considering this range of data points, we think Shenzhen Megmeet Electrical is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Shenzhen Megmeet Electrical (1 is a bit concerning!) that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com