Here's Why Shenzhen Sunnypol OptoelectronicsLtd (SZSE:002876) Has A Meaningful Debt Burden

Warren Buffett famously said, '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. Importantly, Shenzhen Sunnypol Optoelectronics Co.,Ltd. (SZSE:002876) does carry debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shenzhen Sunnypol OptoelectronicsLtd

How Much Debt Does Shenzhen Sunnypol OptoelectronicsLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Shenzhen Sunnypol OptoelectronicsLtd had CN¥1.12b of debt, an increase on CN¥1.02b, over one year. However, it does have CN¥350.1m in cash offsetting this, leading to net debt of about CN¥767.5m.

How Strong Is Shenzhen Sunnypol OptoelectronicsLtd's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Sunnypol OptoelectronicsLtd had liabilities of CN¥1.57b falling due within a year, and liabilities of CN¥185.8m due beyond that. Offsetting these obligations, it had cash of CN¥350.1m as well as receivables valued at CN¥834.0m due within 12 months. So it has liabilities totalling CN¥571.8m more than its cash and near-term receivables, combined.

Given Shenzhen Sunnypol OptoelectronicsLtd has a market capitalization of CN¥4.36b, it's hard to believe these liabilities pose much 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Shenzhen Sunnypol OptoelectronicsLtd's debt to EBITDA ratio (4.9) suggests that it uses some debt, its interest cover is very weak, at 2.0, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Shenzhen Sunnypol OptoelectronicsLtd saw its EBIT tank 86% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Shenzhen Sunnypol OptoelectronicsLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shenzhen Sunnypol OptoelectronicsLtd 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

To be frank both Shenzhen Sunnypol OptoelectronicsLtd's conversion of EBIT to free cash flow 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 Shenzhen Sunnypol OptoelectronicsLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Shenzhen Sunnypol OptoelectronicsLtd that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.