Is Shaanxi Fenghuo Electronics (SZSE:000561) Using Too Much Debt?

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.' 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 Shaanxi Fenghuo Electronics Co., Ltd. (SZSE:000561) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shaanxi Fenghuo Electronics

What Is Shaanxi Fenghuo Electronics's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Shaanxi Fenghuo Electronics had debt of CN¥326.0m, up from CN¥248.9m in one year. However, it also had CN¥188.1m in cash, and so its net debt is CN¥137.9m.

How Strong Is Shaanxi Fenghuo Electronics' Balance Sheet?

We can see from the most recent balance sheet that Shaanxi Fenghuo Electronics had liabilities of CN¥1.92b falling due within a year, and liabilities of CN¥214.0m due beyond that. On the other hand, it had cash of CN¥188.1m and CN¥1.87b worth of receivables due within a year. So it has liabilities totalling CN¥80.0m more than its cash and near-term receivables, combined.

Having regard to Shaanxi Fenghuo Electronics' size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥4.97b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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.

We'd say that Shaanxi Fenghuo Electronics's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its commanding EBIT of 52.0 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Shaanxi Fenghuo Electronics's EBIT fell a jaw-dropping 38% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shaanxi Fenghuo Electronics will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shaanxi Fenghuo 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

Shaanxi Fenghuo Electronics's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Shaanxi Fenghuo Electronics's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 2 warning signs for Shaanxi Fenghuo Electronics that you should be aware of.

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.