Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Forehope Electronic (Ningbo) Co., Ltd. (SHSE:688362) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Forehope Electronic (Ningbo)'s Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Forehope Electronic (Ningbo) had CN¥5.57b of debt, an increase on CN¥3.77b, over one year. However, it does have CN¥2.01b in cash offsetting this, leading to net debt of about CN¥3.56b.

How Strong Is Forehope Electronic (Ningbo)'s Balance Sheet?

The latest balance sheet data shows that Forehope Electronic (Ningbo) had liabilities of CN¥3.54b due within a year, and liabilities of CN¥6.24b falling due after that. Offsetting these obligations, it had cash of CN¥2.01b as well as receivables valued at CN¥681.0m due within 12 months. So its liabilities total CN¥7.09b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Forehope Electronic (Ningbo) is worth CN¥14.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 0.78 times and a disturbingly high net debt to EBITDA ratio of 5.4 hit our confidence in Forehope Electronic (Ningbo) like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Forehope Electronic (Ningbo) is that it turned last year's EBIT loss into a gain of CN¥145m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Forehope Electronic (Ningbo)'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Forehope Electronic (Ningbo) 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

On the face of it, Forehope Electronic (Ningbo)'s interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Forehope Electronic (Ningbo)'s balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Forehope Electronic (Ningbo) (at least 2 which are significant) , 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.