Johnson Electric Holdings (HKG:179) Seems To Use Debt Quite Sensibly

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 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 note that Johnson Electric Holdings Limited (HKG:179) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Johnson Electric Holdings

How Much Debt Does Johnson Electric Holdings Carry?

The image below, which you can click on for greater detail, shows that at September 2021 Johnson Electric Holdings had debt of US$510.0m, up from US$432.6m in one year. However, because it has a cash reserve of US$498.7m, its net debt is less, at about US$11.3m.

How Strong Is Johnson Electric Holdings' Balance Sheet?

According to the last reported balance sheet, Johnson Electric Holdings had liabilities of US$1.07b due within 12 months, and liabilities of US$801.4m due beyond 12 months. On the other hand, it had cash of US$498.7m and US$597.6m worth of receivables due within a year. So its liabilities total US$776.4m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Johnson Electric Holdings has a market capitalization of US$1.80b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Carrying virtually no net debt, Johnson Electric Holdings has a very light debt load indeed.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With debt at a measly 0.025 times EBITDA and EBIT covering interest a whopping 14.7 times, it's clear that Johnson Electric Holdings is not a desperate borrower. So relative to past earnings, the debt load seems trivial. On the other hand, Johnson Electric Holdings's EBIT dived 12%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Johnson Electric Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Johnson Electric Holdings produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Johnson Electric Holdings's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. When we consider all the elements mentioned above, it seems to us that Johnson Electric Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Johnson Electric Holdings 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.