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

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Dongfang Electric Corporation Limited (HKG:1072) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the HK Electrical industry.

What Is Dongfang Electric's Net Debt?

The chart below, which you can click on for greater detail, shows that Dongfang Electric had CN¥1.86b in debt in September 2022; about the same as the year before. However, its balance sheet shows it holds CN¥15.2b in cash, so it actually has CN¥13.4b net cash.

How Strong Is Dongfang Electric's Balance Sheet?

The latest balance sheet data shows that Dongfang Electric had liabilities of CN¥66.3b due within a year, and liabilities of CN¥9.99b falling due after that. Offsetting this, it had CN¥15.2b in cash and CN¥30.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥30.4b.

This deficit isn't so bad because Dongfang Electric is worth CN¥70.4b, 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. 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.

Also positive, Dongfang Electric grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. 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 three 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¥13.4b. And it impressed us with its EBIT growth of 27% over the last year. So we are not troubled with Dongfang Electric's debt use. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Dongfang Electric's earnings per share history for free.

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.