These 4 Measures Indicate That Sun Create Electronics (SHSE:600990) Is Using Debt Extensively

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Sun Create Electronics Co., Ltd (SHSE:600990) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Sun Create Electronics

What Is Sun Create Electronics's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Sun Create Electronics had CN¥2.02b of debt in September 2023, down from CN¥2.16b, one year before. However, because it has a cash reserve of CN¥225.4m, its net debt is less, at about CN¥1.80b.

A Look At Sun Create Electronics' Liabilities

We can see from the most recent balance sheet that Sun Create Electronics had liabilities of CN¥3.78b falling due within a year, and liabilities of CN¥781.3m due beyond that. Offsetting this, it had CN¥225.4m in cash and CN¥2.75b in receivables that were due within 12 months. So its liabilities total CN¥1.58b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sun Create Electronics has a market capitalization of CN¥5.33b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sun Create Electronics shareholders face the double whammy of a high net debt to EBITDA ratio (13.3), and fairly weak interest coverage, since EBIT is just 0.036 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, Sun Create Electronics saw its EBIT tank 99% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Sun Create Electronics can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Sun Create Electronics created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Sun Create Electronics's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, it seems to us that Sun Create Electronics's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Sun Create Electronics (of which 1 can't be ignored!) you should know about.

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.