Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Dongfang Electric Corporation Limited (HKG:1072) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Dongfang Electric's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Dongfang Electric had debt of CN¥1.69b, up from CN¥1.56b in one year. But it also has CN¥18.0b in cash to offset that, meaning it has CN¥16.3b net cash.

How Strong Is Dongfang Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dongfang Electric had liabilities of CN¥71.2b due within 12 months and liabilities of CN¥8.64b due beyond that. Offsetting this, it had CN¥18.0b in cash and CN¥31.1b in receivables that were due within 12 months. So its liabilities total CN¥30.8b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Dongfang Electric has a market capitalization of CN¥52.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Dongfang Electric also has more cash than debt, so we're pretty confident it can manage its debt safely.

On top of that, Dongfang Electric grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Dongfang Electric can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Dongfang Electric 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, Dongfang Electric saw substantial negative free cash flow, in total. 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.

Summing Up

Although Dongfang Electric's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥16.3b. And we liked the look of last year's 33% year-on-year EBIT growth. So we don't have any problem with Dongfang Electric's use of debt. 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. To that end, you should learn about the 2 warning signs we've spotted with Dongfang Electric (including 1 which shouldn't be ignored) .

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.