Wuhan East Lake High Technology Group (SHSE:600133) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Wuhan East Lake High Technology Group Co., Ltd. (SHSE:600133) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Wuhan East Lake High Technology Group

What Is Wuhan East Lake High Technology Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Wuhan East Lake High Technology Group had CN¥5.40b of debt in September 2024, down from CN¥12.3b, one year before. On the flip side, it has CN¥1.64b in cash leading to net debt of about CN¥3.75b.

How Healthy Is Wuhan East Lake High Technology Group's Balance Sheet?

The latest balance sheet data shows that Wuhan East Lake High Technology Group had liabilities of CN¥5.42b due within a year, and liabilities of CN¥3.41b falling due after that. Offsetting this, it had CN¥1.64b in cash and CN¥2.42b in receivables that were due within 12 months. So it has liabilities totalling CN¥4.77b more than its cash and near-term receivables, combined.

Wuhan East Lake High Technology Group has a market capitalization of CN¥10.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Wuhan East Lake High Technology Group has a debt to EBITDA ratio of 4.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that Wuhan East Lake High Technology Group's EBIT was down 26% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is Wuhan East Lake High Technology Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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 that EBIT is backed by free cash flow. Over the last three years, Wuhan East Lake High Technology Group 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, Wuhan East Lake High Technology Group's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, it seems to us that Wuhan East Lake High Technology Group'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. 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. For instance, we've identified 2 warning signs for Wuhan East Lake High Technology Group (1 is a bit concerning) you should be aware of.

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.