Does Shenzhen Megmeet Electrical (SZSE:002851) Have A Healthy Balance Sheet?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Shenzhen Megmeet Electrical Co., LTD (SZSE:002851) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shenzhen Megmeet Electrical

What Is Shenzhen Megmeet Electrical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Shenzhen Megmeet Electrical had CN¥2.37b of debt, an increase on CN¥1.66b, over one year. On the flip side, it has CN¥1.58b in cash leading to net debt of about CN¥787.2m.

How Healthy Is Shenzhen Megmeet Electrical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Megmeet Electrical had liabilities of CN¥5.17b due within 12 months and liabilities of CN¥1.50b due beyond that. Offsetting this, it had CN¥1.58b in cash and CN¥2.87b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.22b.

Since publicly traded Shenzhen Megmeet Electrical shares are worth a total of CN¥26.8b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Shenzhen Megmeet Electrical has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 16.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Shenzhen Megmeet Electrical has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shenzhen Megmeet Electrical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shenzhen Megmeet Electrical saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shenzhen Megmeet Electrical's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Shenzhen Megmeet Electrical is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. We've identified 3 warning signs with Shenzhen Megmeet Electrical , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.