Is Shenzhen Megmeet Electrical (SZSE:002851) 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.' 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. We can see that Shenzhen Megmeet Electrical Co., LTD (SZSE:002851) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shenzhen Megmeet Electrical's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shenzhen Megmeet Electrical had debt of CN¥2.37b, up from CN¥1.66b in 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?

We can see from the most recent balance sheet that Shenzhen Megmeet Electrical had liabilities of CN¥5.17b falling due within a year, and liabilities of CN¥1.50b due beyond that. On the other hand, it had cash of CN¥1.58b and CN¥2.87b worth of receivables due within a year. So its liabilities total CN¥2.22b more than the combination of its cash and short-term receivables.

Since publicly traded Shenzhen Megmeet Electrical shares are worth a total of CN¥32.5b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

Check out our latest analysis for Shenzhen Megmeet Electrical

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 easily covers its interest expense, being 16.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Shenzhen Megmeet Electrical grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shenzhen Megmeet Electrical can strengthen its balance sheet over time. 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shenzhen Megmeet Electrical 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

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. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Shenzhen Megmeet Electrical is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Shenzhen Megmeet Electrical is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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.