Here's Why Sichuan Changhong ElectricLtd (SHSE:600839) 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Sichuan Changhong Electric Co.,Ltd. (SHSE:600839) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sichuan Changhong ElectricLtd

What Is Sichuan Changhong ElectricLtd's Net Debt?

As you can see below, Sichuan Changhong ElectricLtd had CN¥18.1b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. But it also has CN¥24.5b in cash to offset that, meaning it has CN¥6.40b net cash.

How Strong Is Sichuan Changhong ElectricLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sichuan Changhong ElectricLtd had liabilities of CN¥65.6b due within 12 months and liabilities of CN¥4.29b due beyond that. Offsetting this, it had CN¥24.5b in cash and CN¥19.0b in receivables that were due within 12 months. So its liabilities total CN¥26.4b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥41.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Sichuan Changhong ElectricLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Sichuan Changhong ElectricLtd's saving grace is its low debt levels, because its EBIT has tanked 23% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sichuan Changhong ElectricLtd'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. Sichuan Changhong ElectricLtd 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. Over the last three years, Sichuan Changhong ElectricLtd actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While Sichuan Changhong ElectricLtd does have more liabilities than liquid assets, it also has net cash of CN¥6.40b. The cherry on top was that in converted 172% of that EBIT to free cash flow, bringing in CN¥2.1b. So we don't have any problem with Sichuan Changhong ElectricLtd'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. Case in point: We've spotted 3 warning signs for Sichuan Changhong ElectricLtd you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.