Here's Why Weihai Honglin Electronic (SZSE:301439) Can Manage Its Debt Responsibly

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.' 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, Weihai Honglin Electronic Co., Ltd. (SZSE:301439) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Weihai Honglin Electronic

What Is Weihai Honglin Electronic's Debt?

The image below, which you can click on for greater detail, shows that Weihai Honglin Electronic had debt of CN¥35.0m at the end of June 2024, a reduction from CN¥88.6m over a year. But on the other hand it also has CN¥769.3m in cash, leading to a CN¥734.3m net cash position.

How Strong Is Weihai Honglin Electronic's Balance Sheet?

According to the last reported balance sheet, Weihai Honglin Electronic had liabilities of CN¥875.2m due within 12 months, and liabilities of CN¥43.0m due beyond 12 months. On the other hand, it had cash of CN¥769.3m and CN¥1.29b worth of receivables due within a year. So it actually has CN¥1.14b more liquid assets than total liabilities.

This surplus suggests that Weihai Honglin Electronic is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Weihai Honglin Electronic has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Weihai Honglin Electronic if management cannot prevent a repeat of the 30% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Weihai Honglin Electronic will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Weihai Honglin Electronic may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Weihai Honglin Electronic 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.

Summing Up

While it is always sensible to investigate a company's debt, in this case Weihai Honglin Electronic has CN¥734.3m in net cash and a decent-looking balance sheet. So we don't have any problem with Weihai Honglin Electronic's use of debt. 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 example, we've discovered 2 warning signs for Weihai Honglin Electronic (1 is significant!) that you should be aware of before investing here.

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.