We Think Shenyang Fortune Precision Equipment (SHSE:688409) Can Stay On Top Of Its 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. As with many other companies Shenyang Fortune Precision Equipment Co., Ltd. (SHSE:688409) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shenyang Fortune Precision Equipment

What Is Shenyang Fortune Precision Equipment's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shenyang Fortune Precision Equipment had CN¥1.60b of debt, an increase on CN¥892.9m, over one year. On the flip side, it has CN¥1.59b in cash leading to net debt of about CN¥9.09m.

A Look At Shenyang Fortune Precision Equipment's Liabilities

We can see from the most recent balance sheet that Shenyang Fortune Precision Equipment had liabilities of CN¥1.20b falling due within a year, and liabilities of CN¥1.85b due beyond that. Offsetting these obligations, it had cash of CN¥1.59b as well as receivables valued at CN¥1.28b due within 12 months. So its liabilities total CN¥181.8m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Shenyang Fortune Precision Equipment's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥10.9b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Shenyang Fortune Precision Equipment has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenyang Fortune Precision Equipment has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.025. Happily, it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. But the other side of the story is that Shenyang Fortune Precision Equipment saw its EBIT decline by 5.0% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shenyang Fortune Precision Equipment's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shenyang Fortune Precision Equipment burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shenyang Fortune Precision Equipment's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Shenyang Fortune Precision Equipment's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Shenyang Fortune Precision Equipment you should be aware of, and 1 of them is concerning.

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.