Is Hengong Precision Equipment (SZSE:301261) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Hengong Precision Equipment Co., Ltd. (SZSE:301261) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hengong Precision Equipment

What Is Hengong Precision Equipment's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Hengong Precision Equipment had debt of CN¥259.2m, up from CN¥166.1m in one year. However, it does have CN¥918.5m in cash offsetting this, leading to net cash of CN¥659.3m.

A Look At Hengong Precision Equipment's Liabilities

The latest balance sheet data shows that Hengong Precision Equipment had liabilities of CN¥452.0m due within a year, and liabilities of CN¥107.9m falling due after that. Offsetting this, it had CN¥918.5m in cash and CN¥279.0m in receivables that were due within 12 months. So it can boast CN¥637.6m more liquid assets than total liabilities.

This surplus suggests that Hengong Precision Equipment has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Hengong Precision Equipment boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Hengong Precision Equipment saw its EBIT drop by 5.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Hengong Precision Equipment'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Hengong Precision Equipment 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, Hengong Precision Equipment reported free cash flow worth 9.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hengong Precision Equipment has net cash of CN¥659.3m, as well as more liquid assets than liabilities. So we don't have any problem with Hengong Precision Equipment's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Hengong Precision Equipment , and understanding them should be part of your investment process.

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.