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.' 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. Importantly, Shanghai Huace Navigation Technology Ltd (SZSE:300627) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Shanghai Huace Navigation Technology's Debt?
The chart below, which you can click on for greater detail, shows that Shanghai Huace Navigation Technology had CN¥262.8m in debt in September 2023; about the same as the year before. However, it does have CN¥1.12b in cash offsetting this, leading to net cash of CN¥857.7m.
How Strong Is Shanghai Huace Navigation Technology's Balance Sheet?
According to the last reported balance sheet, Shanghai Huace Navigation Technology had liabilities of CN¥1.06b due within 12 months, and liabilities of CN¥235.1m due beyond 12 months. Offsetting this, it had CN¥1.12b in cash and CN¥1.16b in receivables that were due within 12 months. So it actually has CN¥989.7m more liquid assets than total liabilities.
This surplus suggests that Shanghai Huace Navigation Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Shanghai Huace Navigation Technology has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, Shanghai Huace Navigation Technology grew its EBIT by 53% over the last twelve months, and that growth will make it easier to handle its debt. 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 Huace Navigation Technology 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shanghai Huace Navigation Technology has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Shanghai Huace Navigation Technology reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Shanghai Huace Navigation Technology has net cash of CN¥857.7m, as well as more liquid assets than liabilities. And we liked the look of last year's 53% year-on-year EBIT growth. So is Shanghai Huace Navigation Technology's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Shanghai Huace Navigation Technology that 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.