Dongfang Electric (HKG:1072) Has A Pretty Healthy Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Dongfang Electric Corporation Limited (HKG:1072) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Dongfang Electric

What Is Dongfang Electric's Debt?

The image below, which you can click on for greater detail, shows that Dongfang Electric had debt of CN¥1.80b at the end of September 2021, a reduction from CN¥7.74b over a year. But it also has CN¥19.4b in cash to offset that, meaning it has CN¥17.6b net cash.

How Strong Is Dongfang Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dongfang Electric had liabilities of CN¥58.7b due within 12 months and liabilities of CN¥8.92b due beyond that. Offsetting this, it had CN¥19.4b in cash and CN¥28.3b in receivables that were due within 12 months. So it has liabilities totalling CN¥19.9b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Dongfang Electric has a market capitalization of CN¥41.9b, 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. Despite its noteworthy liabilities, Dongfang Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Dongfang Electric grew its EBIT by 2,935% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Dongfang Electric can strengthen its balance sheet over time. 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. Dongfang Electric 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. Over the last two years, Dongfang Electric 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.

Summing up

While Dongfang Electric does have more liabilities than liquid assets, it also has net cash of CN¥17.6b. And it impressed us with its EBIT growth of 2,935% over the last year. So we don't have any problem with Dongfang Electric's use of debt. 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. For example Dongfang Electric has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.