Is Dongguan Aohai Technology (SZSE:002993) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Dongguan Aohai Technology Co., Ltd. (SZSE:002993) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Dongguan Aohai Technology

How Much Debt Does Dongguan Aohai Technology Carry?

The image below, which you can click on for greater detail, shows that at December 2023 Dongguan Aohai Technology had debt of CN¥123.9m, up from CN¥114.1m in one year. But on the other hand it also has CN¥3.67b in cash, leading to a CN¥3.54b net cash position.

A Look At Dongguan Aohai Technology's Liabilities

We can see from the most recent balance sheet that Dongguan Aohai Technology had liabilities of CN¥3.34b falling due within a year, and liabilities of CN¥204.3m due beyond that. Offsetting this, it had CN¥3.67b in cash and CN¥1.89b in receivables that were due within 12 months. So it can boast CN¥2.01b more liquid assets than total liabilities.

It's good to see that Dongguan Aohai Technology has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Dongguan Aohai Technology boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that Dongguan Aohai Technology saw its EBIT decline by 8.1% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dongguan Aohai Technology'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Dongguan Aohai Technology may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Dongguan Aohai Technology's free cash flow amounted to 26% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Dongguan Aohai Technology has CN¥3.54b in net cash and a decent-looking balance sheet. So we are not troubled with Dongguan Aohai Technology's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Dongguan Aohai Technology that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com