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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Shenzhen Sunlord Electronics Co.,Ltd. (SZSE:002138) does use debt in its business. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for Shenzhen Sunlord ElectronicsLtd
You can click the graphic below for the historical numbers, but it shows that Shenzhen Sunlord ElectronicsLtd had CN¥3.32b of debt in September 2024, down from CN¥3.68b, one year before. However, because it has a cash reserve of CN¥333.4m, its net debt is less, at about CN¥2.99b.
The latest balance sheet data shows that Shenzhen Sunlord ElectronicsLtd had liabilities of CN¥2.82b due within a year, and liabilities of CN¥2.98b falling due after that. Offsetting these obligations, it had cash of CN¥333.4m as well as receivables valued at CN¥2.85b due within 12 months. So it has liabilities totalling CN¥2.61b more than its cash and near-term receivables, combined.
Of course, Shenzhen Sunlord ElectronicsLtd has a market capitalization of CN¥23.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Shenzhen Sunlord ElectronicsLtd's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 11.1 times its interest expense, implies the debt load is as light as a peacock feather. It is well worth noting that Shenzhen Sunlord ElectronicsLtd's EBIT shot up like bamboo after rain, gaining 74% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shenzhen Sunlord ElectronicsLtd'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Shenzhen Sunlord ElectronicsLtd created free cash flow amounting to 5.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Happily, Shenzhen Sunlord ElectronicsLtd's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Shenzhen Sunlord ElectronicsLtd can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. We've identified 2 warning signs with Shenzhen Sunlord ElectronicsLtd , and understanding them should be part of your investment process.
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.