These 4 Measures Indicate That Dongfang Electric (HKG:1072) Is Using Debt Reasonably Well

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.' 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. As with many other companies Dongfang Electric Corporation Limited (HKG:1072) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Dongfang Electric

How Much Debt Does Dongfang Electric Carry?

The image below, which you can click on for greater detail, shows that Dongfang Electric had debt of CN¥1.80b at the end of September 2021, a reduction from CN¥7.74b over a year. However, it does have CN¥19.4b in cash offsetting this, leading to net cash of CN¥17.6b.

How Healthy Is Dongfang Electric's Balance Sheet?

The latest balance sheet data shows that Dongfang Electric had liabilities of CN¥58.7b due within a year, and liabilities of CN¥8.92b falling due after that. Offsetting this, it had CN¥19.4b in cash and CN¥28.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥19.9b.

While this might seem like a lot, it is not so bad since Dongfang Electric has a market capitalization of CN¥60.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Dongfang Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that Dongfang Electric grew its EBIT by 2,935% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. 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 two 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

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¥17.6b. And we liked the look of last year's 2,935% year-on-year EBIT growth. So we are not troubled with Dongfang Electric's debt use. 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...

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.