Guoguang Electric (SZSE:002045) Could Easily Take On More Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Guoguang Electric Company Limited (SZSE:002045) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Guoguang Electric

What Is Guoguang Electric's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Guoguang Electric had debt of CN¥2.88b, up from CN¥1.24b in one year. However, it does have CN¥2.86b in cash offsetting this, leading to net debt of about CN¥24.5m.

How Strong Is Guoguang Electric's Balance Sheet?

We can see from the most recent balance sheet that Guoguang Electric had liabilities of CN¥5.52b falling due within a year, and liabilities of CN¥217.8m due beyond that. On the other hand, it had cash of CN¥2.86b and CN¥2.65b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥230.2m.

Given Guoguang Electric has a market capitalization of CN¥9.80b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, Guoguang Electric has a very light debt load indeed.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Guoguang Electric has very modest net debt levels, with net debt at just 0.068 times EBITDA. Humorously, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. Another good sign is that Guoguang Electric has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Guoguang Electric's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Guoguang Electric produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Guoguang Electric's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Zooming out, Guoguang Electric seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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 1 warning sign with Guoguang Electric , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.