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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Daqo New Energy Corp. (NYSE:DQ) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Daqo New Energy Carry?
The image below, which you can click on for greater detail, shows that Daqo New Energy had debt of US$156.6m at the end of June 2021, a reduction from US$264.8m over a year. However, it does have US$237.6m in cash offsetting this, leading to net cash of US$80.9m.
How Healthy Is Daqo New Energy's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Daqo New Energy had liabilities of US$395.3m due within 12 months and liabilities of US$178.2m due beyond that. On the other hand, it had cash of US$237.6m and US$97.0m worth of receivables due within a year. So it has liabilities totalling US$238.9m more than its cash and near-term receivables, combined.
Given Daqo New Energy has a market capitalization of US$5.21b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Daqo New Energy boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Daqo New Energy grew its EBIT by 459% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Daqo New Energy 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. Daqo New Energy 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. Looking at the most recent three years, Daqo New Energy recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
We could understand if investors are concerned about Daqo New Energy's liabilities, but we can be reassured by the fact it has has net cash of US$80.9m. And it impressed us with its EBIT growth of 459% over the last year. So is Daqo New Energy's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Daqo New Energy (of which 1 is concerning!) you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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.
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