Dongfang Electric (HKG:1072) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Dongfang Electric Corporation Limited (HKG:1072) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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¥1.63b at the end of June 2023, a reduction from CN¥1.71b over a year. However, its balance sheet shows it holds CN¥19.1b in cash, so it actually has CN¥17.5b net cash.

A Look At Dongfang Electric's Liabilities

Zooming in on the latest balance sheet data, we can see that Dongfang Electric had liabilities of CN¥77.6b due within 12 months and liabilities of CN¥9.08b due beyond that. Offsetting these obligations, it had cash of CN¥19.1b as well as receivables valued at CN¥35.8b due within 12 months. So its liabilities total CN¥31.8b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥46.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Dongfang Electric also has more cash than debt, so we're pretty confident it can manage its debt safely.

Another good sign is that Dongfang Electric has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. During the last three years, Dongfang Electric burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While Dongfang Electric does have more liabilities than liquid assets, it also has net cash of CN¥17.5b. And we liked the look of last year's 28% year-on-year EBIT growth. So we are not troubled with Dongfang Electric's debt use. 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. To that end, you should be aware of the 1 warning sign we've spotted with Dongfang Electric .

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.