These 4 Measures Indicate That Far East Smarter Energy (SHSE:600869) Is Using Debt In A Risky Way

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Far East Smarter Energy Co., Ltd. (SHSE:600869) does carry debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Far East Smarter Energy

What Is Far East Smarter Energy's Net Debt?

As you can see below, Far East Smarter Energy had CN¥6.80b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥3.15b in cash offsetting this, leading to net debt of about CN¥3.65b.

How Healthy Is Far East Smarter Energy's Balance Sheet?

We can see from the most recent balance sheet that Far East Smarter Energy had liabilities of CN¥14.5b falling due within a year, and liabilities of CN¥2.32b due beyond that. On the other hand, it had cash of CN¥3.15b and CN¥7.77b worth of receivables due within a year. So it has liabilities totalling CN¥5.86b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥9.45b, so it does suggest shareholders should keep an eye on Far East Smarter Energy's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.49 times and a disturbingly high net debt to EBITDA ratio of 7.3 hit our confidence in Far East Smarter Energy like a one-two punch to the gut. The debt burden here is substantial. Worse, Far East Smarter Energy's EBIT was down 83% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Far East Smarter Energy'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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Far East Smarter Energy burned a lot of cash. 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

To be frank both Far East Smarter Energy's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. After considering the datapoints discussed, we think Far East Smarter Energy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Far East Smarter Energy (2 can't be ignored!) 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.