Is Shanghai Moons' Electric (SHSE:603728) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Shanghai Moons' Electric Co., Ltd. (SHSE:603728) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for Shanghai Moons' Electric

How Much Debt Does Shanghai Moons' Electric Carry?

As you can see below, at the end of September 2024, Shanghai Moons' Electric had CN¥375.7m of debt, up from CN¥219.0m a year ago. Click the image for more detail. However, it does have CN¥770.4m in cash offsetting this, leading to net cash of CN¥394.7m.

How Healthy Is Shanghai Moons' Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Moons' Electric had liabilities of CN¥976.0m due within 12 months and liabilities of CN¥107.7m due beyond that. Offsetting this, it had CN¥770.4m in cash and CN¥814.8m in receivables that were due within 12 months. So it actually has CN¥501.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Shanghai Moons' Electric could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shanghai Moons' Electric has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Shanghai Moons' Electric if management cannot prevent a repeat of the 55% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Moons' 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 company can only pay off debt with cold hard cash, not accounting profits. While Shanghai Moons' 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. Considering the last three years, Shanghai Moons' Electric actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Moons' Electric has net cash of CN¥394.7m, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about Shanghai Moons' Electric's balance sheet. 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. For example, we've discovered 2 warning signs for Shanghai Moons' 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.