Here's Why Shenzhen Longsys Electronics (SZSE:301308) Has A Meaningful Debt Burden

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Shenzhen Longsys Electronics Co., Ltd. (SZSE:301308) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shenzhen Longsys Electronics

How Much Debt Does Shenzhen Longsys Electronics Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Shenzhen Longsys Electronics had debt of CN¥7.53b, up from CN¥3.21b in one year. However, it also had CN¥1.28b in cash, and so its net debt is CN¥6.25b.

How Healthy Is Shenzhen Longsys Electronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Longsys Electronics had liabilities of CN¥7.52b due within 12 months and liabilities of CN¥2.38b due beyond that. Offsetting this, it had CN¥1.28b in cash and CN¥1.71b in receivables that were due within 12 months. So its liabilities total CN¥6.90b more than the combination of its cash and short-term receivables.

Of course, Shenzhen Longsys Electronics has a market capitalization of CN¥39.1b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.0, it's fair to say Shenzhen Longsys Electronics does have a significant amount of debt. However, its interest coverage of 4.4 is reasonably strong, which is a good sign. One redeeming factor for Shenzhen Longsys Electronics is that it turned last year's EBIT loss into a gain of CN¥910m, over the last twelve months. 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 Shenzhen Longsys Electronics'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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shenzhen Longsys Electronics saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Shenzhen Longsys Electronics's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Once we consider all the factors above, together, it seems to us that Shenzhen Longsys Electronics's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Shenzhen Longsys Electronics (of which 2 are potentially serious!) 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.