Does Chengdu Xuguang Electronics (SHSE:600353) Have A Healthy Balance Sheet?

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.' 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. We note that Chengdu Xuguang Electronics Co., Ltd. (SHSE:600353) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Chengdu Xuguang Electronics

What Is Chengdu Xuguang Electronics's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Chengdu Xuguang Electronics had debt of CN¥354.2m, up from CN¥287.1m in one year. However, it also had CN¥273.0m in cash, and so its net debt is CN¥81.2m.

How Healthy Is Chengdu Xuguang Electronics' Balance Sheet?

According to the last reported balance sheet, Chengdu Xuguang Electronics had liabilities of CN¥968.5m due within 12 months, and liabilities of CN¥290.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥273.0m as well as receivables valued at CN¥1.29b due within 12 months. So it actually has CN¥305.6m more liquid assets than total liabilities.

This surplus suggests that Chengdu Xuguang Electronics has a conservative balance sheet, and could probably eliminate its debt without much difficulty. But either way, Chengdu Xuguang Electronics has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chengdu Xuguang Electronics has a low net debt to EBITDA ratio of only 0.53. And its EBIT covers its interest expense a whopping 11.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Chengdu Xuguang Electronics saw its EBIT drop by 7.8% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chengdu Xuguang Electronics can strengthen its balance sheet over time. 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 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, Chengdu Xuguang Electronics 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

Chengdu Xuguang Electronics'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. Looking at all this data makes us feel a little cautious about Chengdu Xuguang Electronics's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should be aware of the 1 warning sign we've spotted with Chengdu Xuguang Electronics .

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.