Here's Why Suzhou Dongshan Precision Manufacturing (SZSE:002384) 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.' 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 Suzhou Dongshan Precision Manufacturing Co., Ltd. (SZSE:002384) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Suzhou Dongshan Precision Manufacturing

What Is Suzhou Dongshan Precision Manufacturing's Debt?

The chart below, which you can click on for greater detail, shows that Suzhou Dongshan Precision Manufacturing had CN¥14.0b in debt in March 2024; about the same as the year before. On the flip side, it has CN¥9.73b in cash leading to net debt of about CN¥4.30b.

A Look At Suzhou Dongshan Precision Manufacturing's Liabilities

Zooming in on the latest balance sheet data, we can see that Suzhou Dongshan Precision Manufacturing had liabilities of CN¥18.3b due within 12 months and liabilities of CN¥8.79b due beyond that. On the other hand, it had cash of CN¥9.73b and CN¥6.04b worth of receivables due within a year. So its liabilities total CN¥11.4b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Suzhou Dongshan Precision Manufacturing is worth CN¥40.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Suzhou Dongshan Precision Manufacturing has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 10.4 times over. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Suzhou Dongshan Precision Manufacturing's load is not too heavy, because its EBIT was down 22% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Suzhou Dongshan Precision Manufacturing's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Suzhou Dongshan Precision Manufacturing recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Suzhou Dongshan Precision Manufacturing's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Suzhou Dongshan Precision Manufacturing's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 Suzhou Dongshan Precision Manufacturing is showing 3 warning signs in our investment analysis , you should know about...

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.

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