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 DeHua TB New Decoration Material Co.,Ltd (SZSE:002043) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is DeHua TB New Decoration MaterialLtd's Debt?
As you can see below, DeHua TB New Decoration MaterialLtd had CN¥30.5m of debt at March 2024, down from CN¥313.2m a year prior. However, its balance sheet shows it holds CN¥1.05b in cash, so it actually has CN¥1.02b net cash.
A Look At DeHua TB New Decoration MaterialLtd's Liabilities
According to the last reported balance sheet, DeHua TB New Decoration MaterialLtd had liabilities of CN¥1.92b due within 12 months, and liabilities of CN¥63.9m due beyond 12 months. On the other hand, it had cash of CN¥1.05b and CN¥1.23b worth of receivables due within a year. So it can boast CN¥285.4m more liquid assets than total liabilities.
This surplus suggests that DeHua TB New Decoration MaterialLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that DeHua TB New Decoration MaterialLtd has more cash than debt is arguably a good indication that it can manage its debt safely.
Also positive, DeHua TB New Decoration MaterialLtd grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if DeHua TB New Decoration MaterialLtd 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. DeHua TB New Decoration MaterialLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, DeHua TB New Decoration MaterialLtd actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Summing Up
While it is always sensible to investigate a company's debt, in this case DeHua TB New Decoration MaterialLtd has CN¥1.02b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 112% of that EBIT to free cash flow, bringing in CN¥791m. So we don't think DeHua TB New Decoration MaterialLtd's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that DeHua TB New Decoration MaterialLtd is showing 1 warning sign in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.