Sunward Intelligent Equipment (SZSE:002097) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Sunward Intelligent Equipment Co., Ltd. (SZSE:002097) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sunward Intelligent Equipment

What Is Sunward Intelligent Equipment's Net Debt?

As you can see below, Sunward Intelligent Equipment had CN¥10.2b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥1.76b in cash, and so its net debt is CN¥8.43b.

A Look At Sunward Intelligent Equipment's Liabilities

According to the last reported balance sheet, Sunward Intelligent Equipment had liabilities of CN¥9.61b due within 12 months, and liabilities of CN¥6.99b due beyond 12 months. On the other hand, it had cash of CN¥1.76b and CN¥8.08b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.76b.

This deficit is considerable relative to its market capitalization of CN¥7.50b, so it does suggest shareholders should keep an eye on Sunward Intelligent Equipment'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). 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 0.46 times and a disturbingly high net debt to EBITDA ratio of 13.7 hit our confidence in Sunward Intelligent Equipment like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Sunward Intelligent Equipment achieved a positive EBIT of CN¥149m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Sunward Intelligent Equipment's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Sunward Intelligent Equipment actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Sunward Intelligent Equipment's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Sunward Intelligent Equipment's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Sunward Intelligent Equipment (at least 2 which are concerning) , and understanding them should be part of your investment process.

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.