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 note that Shandong Weida Machinery Co., Ltd. (SZSE:002026) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Shandong Weida Machinery's Debt?
As you can see below, Shandong Weida Machinery had CN¥500.8m of debt at March 2024, down from CN¥641.3m a year prior. But it also has CN¥2.09b in cash to offset that, meaning it has CN¥1.59b net cash.
How Strong Is Shandong Weida Machinery's Balance Sheet?
The latest balance sheet data shows that Shandong Weida Machinery had liabilities of CN¥1.53b due within a year, and liabilities of CN¥66.3m falling due after that. Offsetting this, it had CN¥2.09b in cash and CN¥752.5m in receivables that were due within 12 months. So it can boast CN¥1.25b more liquid assets than total liabilities.
This surplus strongly suggests that Shandong Weida Machinery has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that Shandong Weida Machinery has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Shandong Weida Machinery has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shandong Weida Machinery 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. While Shandong Weida Machinery 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. During the last three years, Shandong Weida Machinery generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Shandong Weida Machinery has net cash of CN¥1.59b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥175m, being 85% of its EBIT. When it comes to Shandong Weida Machinery's debt, we sufficiently relaxed that our mind turns to the jacuzzi. 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. Be aware that Shandong Weida Machinery is showing 1 warning sign in our investment analysis , you should know about...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.