Hengdian Group DMEGC Magnetics Ltd (SZSE:002056) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Hengdian Group DMEGC Magnetics Co. ,Ltd (SZSE:002056) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Hengdian Group DMEGC Magnetics Ltd

What Is Hengdian Group DMEGC Magnetics Ltd's Debt?

You can click the graphic below for the historical numbers, but it shows that Hengdian Group DMEGC Magnetics Ltd had CN¥1.27b of debt in September 2024, down from CN¥3.09b, one year before. However, it does have CN¥6.21b in cash offsetting this, leading to net cash of CN¥4.95b.

A Look At Hengdian Group DMEGC Magnetics Ltd's Liabilities

According to the last reported balance sheet, Hengdian Group DMEGC Magnetics Ltd had liabilities of CN¥11.2b due within 12 months, and liabilities of CN¥547.7m due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.21b as well as receivables valued at CN¥3.36b due within 12 months. So it has liabilities totalling CN¥2.17b more than its cash and near-term receivables, combined.

Of course, Hengdian Group DMEGC Magnetics Ltd has a market capitalization of CN¥22.1b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Hengdian Group DMEGC Magnetics Ltd boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Hengdian Group DMEGC Magnetics Ltd if management cannot prevent a repeat of the 41% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Hengdian Group DMEGC Magnetics Ltd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Hengdian Group DMEGC Magnetics Ltd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Hengdian Group DMEGC Magnetics Ltd generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Hengdian Group DMEGC Magnetics Ltd has CN¥4.95b in net cash. The cherry on top was that in converted 82% of that EBIT to free cash flow, bringing in CN¥146m. So we don't have any problem with Hengdian Group DMEGC Magnetics Ltd's use of debt. 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. Be aware that Hengdian Group DMEGC Magnetics Ltd is showing 3 warning signs in our investment analysis , and 1 of those is significant...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.