Dongyue Group (HKG:189) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Dongyue Group Limited (HKG:189) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Dongyue Group

How Much Debt Does Dongyue Group Carry?

You can click the graphic below for the historical numbers, but it shows that Dongyue Group had CN¥670.6m of debt in June 2022, down from CN¥2.00b, one year before. However, it does have CN¥5.67b in cash offsetting this, leading to net cash of CN¥5.00b.

A Look At Dongyue Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Dongyue Group had liabilities of CN¥6.26b due within 12 months and liabilities of CN¥870.7m due beyond that. Offsetting this, it had CN¥5.67b in cash and CN¥3.15b in receivables that were due within 12 months. So it can boast CN¥1.70b more liquid assets than total liabilities.

This surplus suggests that Dongyue Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Dongyue Group has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Dongyue Group grew its EBIT by 229% last year, which is an impressive improvement. That boost will make it even 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 Dongyue Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Dongyue Group 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. In the last three years, Dongyue Group created free cash flow amounting to 9.9% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Dongyue Group has net cash of CN¥5.00b, as well as more liquid assets than liabilities. And we liked the look of last year's 229% year-on-year EBIT growth. So we don't think Dongyue Group's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Dongyue Group (of which 1 can't be ignored!) 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.

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.