Here's Why Chengdu Xuguang Electronics (SHSE:600353) Can Manage Its Debt Responsibly

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.' 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. As with many other companies Chengdu Xuguang Electronics Co., Ltd. (SHSE:600353) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Chengdu Xuguang Electronics

What Is Chengdu Xuguang Electronics's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Chengdu Xuguang Electronics had CN¥307.4m of debt, an increase on CN¥253.2m, over one year. However, it does have CN¥300.0m in cash offsetting this, leading to net debt of about CN¥7.46m.

A Look At Chengdu Xuguang Electronics' Liabilities

We can see from the most recent balance sheet that Chengdu Xuguang Electronics had liabilities of CN¥876.3m falling due within a year, and liabilities of CN¥263.6m due beyond that. Offsetting these obligations, it had cash of CN¥300.0m as well as receivables valued at CN¥1.25b due within 12 months. So it actually has CN¥410.5m 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 very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.042 and EBIT of 17.0 times the interest expense. So relative to past earnings, the debt load seems trivial. In addition to that, we're happy to report that Chengdu Xuguang Electronics has boosted its EBIT by 45%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Chengdu Xuguang Electronics saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

The good news is that Chengdu Xuguang Electronics's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Taking all this data into account, it seems to us that Chengdu Xuguang Electronics takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Over time, share prices tend to follow earnings per share, so if you're interested in Chengdu Xuguang Electronics, you may well want to click here to check an interactive graph of its earnings per share history.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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