Does Wenzhou Yihua Connector (SZSE:002897) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Wenzhou Yihua Connector Co., Ltd. (SZSE:002897) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Wenzhou Yihua Connector

What Is Wenzhou Yihua Connector's Net Debt?

As you can see below, at the end of June 2024, Wenzhou Yihua Connector had CN¥2.40b of debt, up from CN¥2.28b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.10b, its net debt is less, at about CN¥1.30b.

How Strong Is Wenzhou Yihua Connector's Balance Sheet?

We can see from the most recent balance sheet that Wenzhou Yihua Connector had liabilities of CN¥3.18b falling due within a year, and liabilities of CN¥904.0m due beyond that. Offsetting this, it had CN¥1.10b in cash and CN¥1.70b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.28b.

Since publicly traded Wenzhou Yihua Connector shares are worth a total of CN¥8.63b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Wenzhou Yihua Connector's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that Wenzhou Yihua Connector grew its EBIT a smooth 81% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Wenzhou Yihua Connector'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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Wenzhou Yihua Connector 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

Wenzhou Yihua Connector's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about Wenzhou Yihua Connector's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that Wenzhou Yihua Connector is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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.