Here's Why Dongfang Electric (HKG:1072) Can Manage Its Debt Responsibly

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 can see that Dongfang Electric Corporation Limited (HKG:1072) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Dongfang Electric

What Is Dongfang Electric's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Dongfang Electric had CN¥1.71b of debt, an increase on CN¥1.14b, over one year. However, it does have CN¥16.6b in cash offsetting this, leading to net cash of CN¥14.9b.

A Look At Dongfang Electric's Liabilities

The latest balance sheet data shows that Dongfang Electric had liabilities of CN¥57.1b due within a year, and liabilities of CN¥10.1b falling due after that. Offsetting these obligations, it had cash of CN¥16.6b as well as receivables valued at CN¥29.4b due within 12 months. So it has liabilities totalling CN¥21.1b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Dongfang Electric is worth CN¥50.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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!

The good news is that Dongfang Electric has increased its EBIT by 9.8% over twelve months, which should ease any concerns about debt repayment. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Dongfang Electric has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. 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¥14.9b. On top of that, it increased its EBIT by 9.8% in the last twelve months. So we don't have any problem with Dongfang Electric's use of debt. 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. Be aware that Dongfang Electric is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.