Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Gree Electric Appliances, Inc. of Zhuhai (SZSE:000651) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Gree Electric Appliances of Zhuhai Carry?
As you can see below, at the end of September 2023, Gree Electric Appliances of Zhuhai had CN¥91.2b of debt, up from CN¥85.0b a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥186.7b in cash, so it actually has CN¥95.5b net cash.
How Strong Is Gree Electric Appliances of Zhuhai's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Gree Electric Appliances of Zhuhai had liabilities of CN¥220.6b due within 12 months and liabilities of CN¥48.5b due beyond that. On the other hand, it had cash of CN¥186.7b and CN¥40.3b worth of receivables due within a year. So it has liabilities totalling CN¥42.0b more than its cash and near-term receivables, combined.
Since publicly traded Gree Electric Appliances of Zhuhai shares are worth a very impressive total of CN¥211.2b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Gree Electric Appliances of Zhuhai also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the other side of the story is that Gree Electric Appliances of Zhuhai saw its EBIT decline by 8.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Gree Electric Appliances of Zhuhai's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Gree Electric Appliances of Zhuhai 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, Gree Electric Appliances of Zhuhai recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Summing Up
While Gree Electric Appliances of Zhuhai does have more liabilities than liquid assets, it also has net cash of CN¥95.5b. The cherry on top was that in converted 94% of that EBIT to free cash flow, bringing in CN¥40b. So we don't have any problem with Gree Electric Appliances of Zhuhai's use of debt. 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 1 warning sign for Gree Electric Appliances of Zhuhai you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.