We Think Shanghai Fudan Microelectronics Group (HKG:1385) Is Taking Some Risk With Its Debt

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.' 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, Shanghai Fudan Microelectronics Group Company Limited (HKG:1385) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shanghai Fudan Microelectronics Group

What Is Shanghai Fudan Microelectronics Group's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Shanghai Fudan Microelectronics Group had debt of CN¥1.45b, up from CN¥397.4m in one year. However, it does have CN¥886.0m in cash offsetting this, leading to net debt of about CN¥559.7m.

A Look At Shanghai Fudan Microelectronics Group's Liabilities

We can see from the most recent balance sheet that Shanghai Fudan Microelectronics Group had liabilities of CN¥1.86b falling due within a year, and liabilities of CN¥505.4m due beyond that. Offsetting this, it had CN¥886.0m in cash and CN¥1.63b in receivables that were due within 12 months. So it actually has CN¥155.2m more liquid assets than total liabilities.

This state of affairs indicates that Shanghai Fudan Microelectronics Group's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥20.2b company is struggling for cash, we still think it's worth monitoring its 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shanghai Fudan Microelectronics Group's net debt is only 0.77 times its EBITDA. And its EBIT easily covers its interest expense, being 31.8 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Shanghai Fudan Microelectronics Group's load is not too heavy, because its EBIT was down 44% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shanghai Fudan Microelectronics Group 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.

Our View

Shanghai Fudan Microelectronics Group's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Shanghai Fudan Microelectronics Group's debt poses some risks to the business. 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. Case in point: We've spotted 2 warning signs for Shanghai Fudan Microelectronics Group you should be aware of, and 1 of them can't be ignored.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.