Xi'an Sinofuse Electric (SZSE:301031) Seems To Use Debt Quite Sensibly

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. Importantly, Xi'an Sinofuse Electric Co., Ltd. (SZSE:301031) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Xi'an Sinofuse Electric

What Is Xi'an Sinofuse Electric's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Xi'an Sinofuse Electric had debt of CN¥282.0m, up from CN¥215.6m in one year. However, it does have CN¥205.5m in cash offsetting this, leading to net debt of about CN¥76.5m.

How Healthy Is Xi'an Sinofuse Electric's Balance Sheet?

According to the last reported balance sheet, Xi'an Sinofuse Electric had liabilities of CN¥839.3m due within 12 months, and liabilities of CN¥5.45m due beyond 12 months. Offsetting this, it had CN¥205.5m in cash and CN¥865.5m in receivables that were due within 12 months. So it can boast CN¥226.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Xi'an Sinofuse Electric could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, Xi'an Sinofuse Electric has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

Xi'an Sinofuse Electric has a low net debt to EBITDA ratio of only 0.36. And its EBIT easily covers its interest expense, being 29.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Xi'an Sinofuse Electric has increased its EBIT by 6.5% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Xi'an Sinofuse Electric 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Xi'an Sinofuse Electric 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

Based on what we've seen Xi'an Sinofuse Electric is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. 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 Xi'an Sinofuse Electric 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Xi'an Sinofuse Electric that you should be aware of.

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.