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.' 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. We can see that Shanghai Fudan Microelectronics Group Company Limited (HKG:1385) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shanghai Fudan Microelectronics Group

What Is Shanghai Fudan Microelectronics Group's Debt?

As you can see below, at the end of March 2024, Shanghai Fudan Microelectronics Group had CN¥1.45b of debt, up from CN¥397.4m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥886.0m, its net debt is less, at about CN¥559.7m.

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

Zooming in on the latest balance sheet data, we can see that Shanghai Fudan Microelectronics Group had liabilities of CN¥1.86b due within 12 months and liabilities of CN¥505.4m due beyond that. Offsetting these obligations, it had cash of CN¥886.0m as well as receivables valued at CN¥1.63b due within 12 months. So it can boast CN¥155.2m 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 while it's hard to imagine that the CN¥18.2b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Fudan Microelectronics Group has a low net debt to EBITDA ratio of only 0.77. And its EBIT covers its interest expense a whopping 31.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Shanghai Fudan Microelectronics Group's saving grace is its low debt levels, because its EBIT has tanked 44% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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. During the last three years, Shanghai Fudan Microelectronics Group burned a lot of cash. 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. 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. We've identified 2 warning signs with Shanghai Fudan Microelectronics Group (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.