The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, China Electric Mfg. Corporation (TPE:1611) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is China Electric Mfg's Net Debt?
You can click the graphic below for the historical numbers, but it shows that China Electric Mfg had NT$701.0m of debt in September 2020, down from NT$1.21b, one year before. However, its balance sheet shows it holds NT$1.55b in cash, so it actually has NT$845.1m net cash.
How Healthy Is China Electric Mfg's Balance Sheet?
We can see from the most recent balance sheet that China Electric Mfg had liabilities of NT$1.20b falling due within a year, and liabilities of NT$741.9m due beyond that. Offsetting this, it had NT$1.55b in cash and NT$348.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$44.0m.
Having regard to China Electric Mfg's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the NT$4.31b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, China Electric Mfg also has more cash than debt, so we're pretty confident it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Electric Mfg will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
In the last year China Electric Mfg had a loss before interest and tax, and actually shrunk its revenue by 6.5%, to NT$2.2b. That's not what we would hope to see.
So How Risky Is China Electric Mfg?
Although China Electric Mfg had an earnings before interest and tax (EBIT) loss over the last twelve months, it made a statutory profit of NT$806m. So taking that on face value, and considering the cash, we don't think its very risky in the near term. With revenue growth uninspiring, we'd really need to see some positive EBIT before mustering much enthusiasm for this business. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for China Electric Mfg that you should be aware of.
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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