Is Shanghai Fudan Microelectronics Group (HKG:1385) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Shanghai Fudan Microelectronics Group Company Limited (HKG:1385) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.

See 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 2024 Shanghai Fudan Microelectronics Group had debt of CN¥1.69b, up from CN¥1.40b in one year. However, it also had CN¥1.01b in cash, and so its net debt is CN¥671.2m.

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¥2.21b falling due within a year, and liabilities of CN¥289.4m due beyond that. Offsetting these obligations, it had cash of CN¥1.01b as well as receivables valued at CN¥1.85b due within 12 months. So it actually has CN¥366.1m more liquid assets than total liabilities.

Having regard to Shanghai Fudan Microelectronics Group's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥28.8b company is short on cash, but still worth keeping an eye on the balance sheet.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Fudan Microelectronics Group's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 15.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Shanghai Fudan Microelectronics Group's load is not too heavy, because its EBIT was down 58% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shanghai Fudan Microelectronics Group'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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shanghai Fudan Microelectronics Group 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.

Our View

Neither Shanghai Fudan Microelectronics Group's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Shanghai Fudan Microelectronics Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. 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 2 warning signs for Shanghai Fudan Microelectronics Group you should know about.

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.

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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.