Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Guangdong Champion Asia Electronics Co.,Ltd. (SHSE:603386) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Guangdong Champion Asia ElectronicsLtd

What Is Guangdong Champion Asia ElectronicsLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Guangdong Champion Asia ElectronicsLtd had CN¥967.5m of debt, an increase on CN¥759.0m, over one year. However, it does have CN¥127.2m in cash offsetting this, leading to net debt of about CN¥840.4m.

How Strong Is Guangdong Champion Asia ElectronicsLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangdong Champion Asia ElectronicsLtd had liabilities of CN¥1.75b due within 12 months and liabilities of CN¥387.2m due beyond that. Offsetting this, it had CN¥127.2m in cash and CN¥803.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.21b.

This deficit isn't so bad because Guangdong Champion Asia ElectronicsLtd is worth CN¥3.81b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt to EBITDA of 2.7 Guangdong Champion Asia ElectronicsLtd has a fairly noticeable amount of debt. But the high interest coverage of 7.7 suggests it can easily service that debt. Notably Guangdong Champion Asia ElectronicsLtd's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is Guangdong Champion Asia ElectronicsLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Guangdong Champion Asia ElectronicsLtd basically broke even on a free cash flow basis. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

Guangdong Champion Asia ElectronicsLtd's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. Taking the abovementioned factors together we do think Guangdong Champion Asia ElectronicsLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Guangdong Champion Asia ElectronicsLtd (of which 1 doesn't sit too well with us!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.