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

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. As with many other companies Dongfang Electric Corporation Limited (HKG:1072) makes use of debt. But should shareholders be worried about its use of debt?

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. 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, 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 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?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Dongfang Electric had CN¥2.97b of debt, an increase on CN¥1.72b, over one year. But it also has CN¥15.8b in cash to offset that, meaning it has CN¥12.8b net cash.

How Healthy Is Dongfang Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dongfang Electric had liabilities of CN¥86.2b due within 12 months and liabilities of CN¥10.0b due beyond that. Offsetting these obligations, it had cash of CN¥15.8b as well as receivables valued at CN¥34.4b due within 12 months. So it has liabilities totalling CN¥46.0b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥44.8b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Given that Dongfang Electric has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

On top of that, Dongfang Electric grew its EBIT by 45% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 three years, Dongfang Electric actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While Dongfang Electric does have more liabilities than liquid assets, it also has net cash of CN¥12.8b. The cherry on top was that in converted 178% of that EBIT to free cash flow, bringing in CN¥4.4b. So we don't have any problem with Dongfang Electric's use of debt. 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. We've identified 1 warning sign with Dongfang Electric , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.