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.' 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 note that Dongfang Electric Corporation Limited (HKG:1072) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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, 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Dongfang Electric

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 Healthy Is Dongfang Electric's Balance Sheet?

According to the last reported balance sheet, Dongfang Electric had liabilities of CN¥66.3b due within 12 months, and liabilities of CN¥9.99b due beyond 12 months. Offsetting this, it had CN¥15.2b in cash and CN¥30.7b in receivables that were due within 12 months. So it has liabilities totalling CN¥30.4b 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¥59.9b, 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. 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 27% 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 it is future earnings, more than anything, that will determine Dongfang Electric's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept 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. Over the last three years, Dongfang Electric saw substantial negative free cash flow, in total. 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¥13.4b. And it impressed us with its EBIT growth of 27% over the last year. So we don't have any problem with Dongfang Electric's use of debt. 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, 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.