Here's Why Funeng Oriental Equipment Technology (SZSE:300173) Has A Meaningful Debt Burden

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.' 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. We note that Funeng Oriental Equipment Technology Co., Ltd. (SZSE:300173) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Funeng Oriental Equipment Technology

How Much Debt Does Funeng Oriental Equipment Technology Carry?

As you can see below, at the end of September 2024, Funeng Oriental Equipment Technology had CN¥996.1m of debt, up from CN¥408.1m a year ago. Click the image for more detail. However, it does have CN¥139.9m in cash offsetting this, leading to net debt of about CN¥856.2m.

How Healthy Is Funeng Oriental Equipment Technology's Balance Sheet?

The latest balance sheet data shows that Funeng Oriental Equipment Technology had liabilities of CN¥2.79b due within a year, and liabilities of CN¥355.5m falling due after that. Offsetting this, it had CN¥139.9m in cash and CN¥646.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥2.36b more than its cash and near-term receivables, combined.

Funeng Oriental Equipment Technology has a market capitalization of CN¥6.08b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

With a net debt to EBITDA ratio of 17.1, it's fair to say Funeng Oriental Equipment Technology does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.7 times, suggesting it can responsibly service its obligations. We also note that Funeng Oriental Equipment Technology improved its EBIT from a last year's loss to a positive CN¥32m. There's no doubt that we learn most about debt from the balance sheet. But it is Funeng Oriental Equipment Technology's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Funeng Oriental Equipment Technology saw substantial negative free cash flow, in total. 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

To be frank both Funeng Oriental Equipment Technology's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Funeng Oriental Equipment Technology's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 Funeng Oriental Equipment Technology (at least 2 which can't be ignored) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.