Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Dongfang Electric Corporation Limited (HKG:1072) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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.
How Much Debt Does Dongfang Electric Carry?
As you can see below, at the end of March 2024, Dongfang Electric had CN¥2.08b of debt, up from CN¥1.72b a year ago. Click the image for more detail. But on the other hand it also has CN¥18.2b in cash, leading to a CN¥16.1b net cash position.
How Strong Is Dongfang Electric's Balance Sheet?
According to the last reported balance sheet, Dongfang Electric had liabilities of CN¥77.3b due within 12 months, and liabilities of CN¥8.78b due beyond 12 months. On the other hand, it had cash of CN¥18.2b and CN¥33.3b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥34.6b.
This deficit is considerable relative to its market capitalization of CN¥46.3b, so it does suggest shareholders should keep an eye on Dongfang Electric's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Dongfang Electric boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Dongfang Electric has boosted its EBIT by 38%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dongfang Electric's ability to maintain a healthy balance sheet going forward. 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 Dongfang Electric 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, Dongfang Electric produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Summing Up
Although Dongfang Electric's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥16.1b. And we liked the look of last year's 38% year-on-year EBIT growth. So we don't have any problem with Dongfang Electric's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Dongfang Electric that you should be aware of before investing here.
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.
