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 China National Electric Apparatus Research Institute Co., Ltd. (SHSE:688128) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is China National Electric Apparatus Research Institute's Net Debt?
You can click the graphic below for the historical numbers, but it shows that China National Electric Apparatus Research Institute had CN¥13.5m of debt in March 2024, down from CN¥46.3m, one year before. However, its balance sheet shows it holds CN¥732.9m in cash, so it actually has CN¥719.4m net cash.
A Look At China National Electric Apparatus Research Institute's Liabilities
The latest balance sheet data shows that China National Electric Apparatus Research Institute had liabilities of CN¥3.96b due within a year, and liabilities of CN¥204.3m falling due after that. On the other hand, it had cash of CN¥732.9m and CN¥1.79b worth of receivables due within a year. So its liabilities total CN¥1.64b more than the combination of its cash and short-term receivables.
China National Electric Apparatus Research Institute has a market capitalization of CN¥7.75b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, China National Electric Apparatus Research Institute boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that China National Electric Apparatus Research Institute grew its EBIT at 18% over the last year, further increasing its ability to manage debt. 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 China National Electric Apparatus Research Institute's ability to maintain a healthy balance sheet going forward. 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. China National Electric Apparatus Research Institute 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 most recent three years, China National Electric Apparatus Research Institute recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Summing Up
Although China National Electric Apparatus Research Institute'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¥719.4m. And we liked the look of last year's 18% year-on-year EBIT growth. So is China National Electric Apparatus Research Institute's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with China National Electric Apparatus Research Institute .
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.
