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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Zhuzhou Hongda Electronics Corp.,Ltd. (SZSE:300726) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Zhuzhou Hongda ElectronicsLtd's Net Debt?
As you can see below, Zhuzhou Hongda ElectronicsLtd had CN¥12.0m of debt at March 2024, down from CN¥25.0m a year prior. But it also has CN¥1.33b in cash to offset that, meaning it has CN¥1.31b net cash.
How Healthy Is Zhuzhou Hongda ElectronicsLtd's Balance Sheet?
The latest balance sheet data shows that Zhuzhou Hongda ElectronicsLtd had liabilities of CN¥423.8m due within a year, and liabilities of CN¥207.3m falling due after that. On the other hand, it had cash of CN¥1.33b and CN¥1.99b worth of receivables due within a year. So it can boast CN¥2.69b more liquid assets than total liabilities.
It's good to see that Zhuzhou Hongda ElectronicsLtd has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Zhuzhou Hongda ElectronicsLtd has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Zhuzhou Hongda ElectronicsLtd's saving grace is its low debt levels, because its EBIT has tanked 55% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Zhuzhou Hongda ElectronicsLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Zhuzhou Hongda ElectronicsLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Zhuzhou Hongda ElectronicsLtd's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Zhuzhou Hongda ElectronicsLtd has net cash of CN¥1.31b, as well as more liquid assets than liabilities. So we are not troubled with Zhuzhou Hongda ElectronicsLtd's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Zhuzhou Hongda ElectronicsLtd , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.