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Is Dongfang Electric (HKG:1072) A Risky Investment?

Simply Wall St

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Dongfang Electric Corporation Limited (HKG:1072) 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Dongfang Electric

What Is Dongfang Electric's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2019 Dongfang Electric had CN¥370.5m of debt, an increase on CN¥935, over one year. But on the other hand it also has CN¥27.8b in cash, leading to a CN¥27.4b net cash position.

SEHK:1072 Historical Debt, January 16th 2020

A Look At Dongfang Electric's Liabilities

We can see from the most recent balance sheet that Dongfang Electric had liabilities of CN¥49.5b falling due within a year, and liabilities of CN¥8.18b due beyond that. Offsetting these obligations, it had cash of CN¥27.8b as well as receivables valued at CN¥25.8b due within 12 months. So it has liabilities totalling CN¥4.07b more than its cash and near-term receivables, combined.

Of course, Dongfang Electric has a market capitalization of CN¥27.5b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Dongfang Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

Also positive, Dongfang Electric grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. 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 Dongfang Electric'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, a company can only pay off debt with cold hard cash, not accounting profits. 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 two 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¥27.4b. And we liked the look of last year's 28% year-on-year EBIT growth. So we are not troubled with Dongfang Electric's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Dongfang Electric is showing 1 warning sign in our investment analysis , 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.