Is Dongfang Electric (HKG:1072) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Dongfang Electric Corporation Limited (HKG:1072) does use debt in its business. But the real question is whether this debt is making the company risky.

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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¥1.72b at the end of September 2023, a reduction from CN¥1.86b over a year. But it also has CN¥18.4b in cash to offset that, meaning it has CN¥16.7b net cash.

A Look At Dongfang Electric's Liabilities

According to the last reported balance sheet, Dongfang Electric had liabilities of CN¥77.4b due within 12 months, and liabilities of CN¥9.31b due beyond 12 months. Offsetting these obligations, it had cash of CN¥18.4b as well as receivables valued at CN¥36.1b due within 12 months. So it has liabilities totalling CN¥32.2b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥42.9b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Dongfang Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Dongfang Electric's load is not too heavy, because its EBIT was down 24% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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. 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

Although Dongfang Electric's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥16.7b. Despite its cash we think that Dongfang Electric seems to struggle to grow its EBIT, so we are wary of the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Dongfang Electric that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.