David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Sumec Corporation Limited (SHSE:600710) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Sumec's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2023 Sumec had debt of CN¥6.73b, up from CN¥3.03b in one year. However, it does have CN¥14.7b in cash offsetting this, leading to net cash of CN¥8.01b.
How Strong Is Sumec's Balance Sheet?
We can see from the most recent balance sheet that Sumec had liabilities of CN¥41.1b falling due within a year, and liabilities of CN¥2.51b due beyond that. Offsetting this, it had CN¥14.7b in cash and CN¥12.9b in receivables that were due within 12 months. So it has liabilities totalling CN¥16.0b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥10.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Sumec would probably need a major re-capitalization if its creditors were to demand repayment. Sumec boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
Fortunately, Sumec grew its EBIT by 4.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sumec 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 company can only pay off debt with cold hard cash, not accounting profits. Sumec may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Sumec actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Summing Up
While Sumec does have more liabilities than liquid assets, it also has net cash of CN¥8.01b. The cherry on top was that in converted 121% of that EBIT to free cash flow, bringing in CN¥1.8b. So we are not troubled with Sumec's debt use. 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. For example - Sumec has 1 warning sign we think 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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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.