Is Wuhan P&S Information Technology (SZSE:300184) A Risky Investment?

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. As with many other companies Wuhan P&S Information Technology Co., Ltd. (SZSE:300184) makes use of debt. But is this debt a concern to shareholders?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Wuhan P&S Information Technology

What Is Wuhan P&S Information Technology's Debt?

As you can see below, Wuhan P&S Information Technology had CN¥894.7m of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥683.7m, its net debt is less, at about CN¥211.0m.

How Strong Is Wuhan P&S Information Technology's Balance Sheet?

We can see from the most recent balance sheet that Wuhan P&S Information Technology had liabilities of CN¥2.17b falling due within a year, and liabilities of CN¥90.7m due beyond that. Offsetting these obligations, it had cash of CN¥683.7m as well as receivables valued at CN¥2.35b due within 12 months. So it actually has CN¥773.6m more liquid assets than total liabilities.

This surplus suggests that Wuhan P&S Information Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 Wuhan P&S Information Technology's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. If Wuhan P&S Information Technology can keep growing EBIT at last year's rate of 18% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is Wuhan P&S Information Technology's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Considering the last three years, Wuhan P&S Information Technology actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Wuhan P&S Information Technology's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that it has an adequate capacity to grow its EBIT. Considering this range of data points, we think Wuhan P&S Information Technology is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 1 warning sign for Wuhan P&S Information Technology you should be aware of.

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.