These 4 Measures Indicate That Sunwoda ElectronicLtd (SZSE:300207) Is Using Debt Extensively

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.' 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 can see that Sunwoda Electronic Co.,Ltd (SZSE:300207) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sunwoda ElectronicLtd

What Is Sunwoda ElectronicLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Sunwoda ElectronicLtd had debt of CN¥19.6b, up from CN¥18.8b in one year. However, because it has a cash reserve of CN¥17.9b, its net debt is less, at about CN¥1.69b.

How Healthy Is Sunwoda ElectronicLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sunwoda ElectronicLtd had liabilities of CN¥38.6b due within 12 months and liabilities of CN¥14.6b due beyond that. On the other hand, it had cash of CN¥17.9b and CN¥15.6b worth of receivables due within a year. So its liabilities total CN¥19.6b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sunwoda ElectronicLtd has a market capitalization of CN¥42.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Sunwoda ElectronicLtd's low debt to EBITDA ratio of 0.61 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.1 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Sunwoda ElectronicLtd's EBIT launched higher than Elon Musk, gaining a whopping 179% on last year. 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 Sunwoda ElectronicLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sunwoda ElectronicLtd 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

Sunwoda ElectronicLtd's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Sunwoda ElectronicLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Sunwoda ElectronicLtd's earnings per share history for free.

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.