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. We note that Hengdian Group DMEGC Magnetics Co. ,Ltd (SZSE:002056) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hengdian Group DMEGC Magnetics Ltd's Debt?
The image below, which you can click on for greater detail, shows that at March 2024 Hengdian Group DMEGC Magnetics Ltd had debt of CN¥2.79b, up from CN¥1.41b in one year. However, its balance sheet shows it holds CN¥8.41b in cash, so it actually has CN¥5.61b net cash.
How Strong Is Hengdian Group DMEGC Magnetics Ltd's Balance Sheet?
The latest balance sheet data shows that Hengdian Group DMEGC Magnetics Ltd had liabilities of CN¥11.8b due within a year, and liabilities of CN¥641.6m falling due after that. Offsetting this, it had CN¥8.41b in cash and CN¥3.60b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥450.7m.
Given Hengdian Group DMEGC Magnetics Ltd has a market capitalization of CN¥21.7b, it's hard to believe these liabilities pose much 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, Hengdian Group DMEGC Magnetics Ltd also has more cash than debt, so we're pretty confident it can manage its debt safely.
While Hengdian Group DMEGC Magnetics Ltd doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hengdian Group DMEGC Magnetics Ltd'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Hengdian Group DMEGC Magnetics Ltd 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. During the last three years, Hengdian Group DMEGC Magnetics Ltd produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Summing Up
We could understand if investors are concerned about Hengdian Group DMEGC Magnetics Ltd's liabilities, but we can be reassured by the fact it has has net cash of CN¥5.61b. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in CN¥2.1b. So we don't think Hengdian Group DMEGC Magnetics Ltd's use of debt is risky. 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. We've identified 1 warning sign with Hengdian Group DMEGC Magnetics Ltd , and understanding them should be part of your investment process.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.