Here's Why Shanghai Fudan Microelectronics Group (HKG:1385) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Shanghai Fudan Microelectronics Group Company Limited (HKG:1385) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 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, 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shanghai Fudan Microelectronics Group

What Is Shanghai Fudan Microelectronics Group's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 Shanghai Fudan Microelectronics Group had debt of CN¥63.3m, up from none in one year. But it also has CN¥1.14b in cash to offset that, meaning it has CN¥1.07b net cash.

How Healthy Is Shanghai Fudan Microelectronics Group's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Fudan Microelectronics Group had liabilities of CN¥676.3m falling due within a year, and liabilities of CN¥137.3m due beyond that. On the other hand, it had cash of CN¥1.14b and CN¥864.6m worth of receivables due within a year. So it actually has CN¥1.19b more liquid assets than total liabilities.

This short term liquidity is a sign that Shanghai Fudan Microelectronics Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shanghai Fudan Microelectronics Group has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Shanghai Fudan Microelectronics Group grew its EBIT by 631% last year, which is an impressive improvement. 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 ultimately the future profitability of the business will decide if Shanghai Fudan Microelectronics Group 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. Shanghai Fudan Microelectronics 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 two years, Shanghai Fudan Microelectronics Group created free cash flow amounting to 17% 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 it is always sensible to investigate a company's debt, in this case Shanghai Fudan Microelectronics Group has CN¥1.07b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 631% over the last year. So we don't think Shanghai Fudan Microelectronics Group's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Shanghai Fudan Microelectronics Group you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.