Is Estun Automation (SZSE:002747) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Estun Automation Co., Ltd (SZSE:002747) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Estun Automation

What Is Estun Automation's Debt?

As you can see below, at the end of September 2024, Estun Automation had CN¥4.58b of debt, up from CN¥4.37b a year ago. Click the image for more detail. On the flip side, it has CN¥1.53b in cash leading to net debt of about CN¥3.05b.

How Healthy Is Estun Automation's Balance Sheet?

According to the last reported balance sheet, Estun Automation had liabilities of CN¥5.34b due within 12 months, and liabilities of CN¥2.34b due beyond 12 months. On the other hand, it had cash of CN¥1.53b and CN¥2.92b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.23b.

This deficit isn't so bad because Estun Automation is worth CN¥16.1b, and thus could probably raise enough capital to shore up 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.51 times and a disturbingly high net debt to EBITDA ratio of 17.0 hit our confidence in Estun Automation like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Estun Automation saw its EBIT tank 82% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Estun Automation'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Estun Automation burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Estun Automation'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. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Estun Automation to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Estun Automation that 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.

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.