Here's Why Hengtong Optic-Electric (SHSE:600487) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Hengtong Optic-Electric Co., Ltd. (SHSE:600487) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Hengtong Optic-Electric

How Much Debt Does Hengtong Optic-Electric Carry?

As you can see below, at the end of September 2023, Hengtong Optic-Electric had CN¥17.3b of debt, up from CN¥14.7b a year ago. Click the image for more detail. On the flip side, it has CN¥9.24b in cash leading to net debt of about CN¥8.06b.

How Healthy Is Hengtong Optic-Electric's Balance Sheet?

According to the last reported balance sheet, Hengtong Optic-Electric had liabilities of CN¥27.2b due within 12 months, and liabilities of CN¥6.12b due beyond 12 months. Offsetting these obligations, it had cash of CN¥9.24b as well as receivables valued at CN¥23.1b due within 12 months. So its liabilities total CN¥982.0m more than the combination of its cash and short-term receivables.

Since publicly traded Hengtong Optic-Electric shares are worth a total of CN¥30.4b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

We'd say that Hengtong Optic-Electric's moderate net debt to EBITDA ratio ( being 2.5), indicates prudence when it comes to debt. And its strong interest cover of 11.8 times, makes us even more comfortable. The bad news is that Hengtong Optic-Electric saw its EBIT decline by 12% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hengtong Optic-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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hengtong Optic-Electric saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Hengtong Optic-Electric's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its interest cover was refreshing. Taking the abovementioned factors together we do think Hengtong Optic-Electric's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 1 warning sign with Hengtong Optic-Electric , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.