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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Asia Cuanon Technology (Shanghai) Co.,Ltd. (SHSE:603378) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Asia Cuanon Technology (Shanghai)Ltd

What Is Asia Cuanon Technology (Shanghai)Ltd's Net Debt?

The chart below, which you can click on for greater detail, shows that Asia Cuanon Technology (Shanghai)Ltd had CN¥1.97b in debt in June 2023; about the same as the year before. On the flip side, it has CN¥313.9m in cash leading to net debt of about CN¥1.66b.

A Look At Asia Cuanon Technology (Shanghai)Ltd's Liabilities

The latest balance sheet data shows that Asia Cuanon Technology (Shanghai)Ltd had liabilities of CN¥4.36b due within a year, and liabilities of CN¥820.6m falling due after that. Offsetting this, it had CN¥313.9m in cash and CN¥2.45b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.41b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥3.92b, so it does suggest shareholders should keep an eye on Asia Cuanon Technology (Shanghai)Ltd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Weak interest cover of 0.79 times and a disturbingly high net debt to EBITDA ratio of 8.7 hit our confidence in Asia Cuanon Technology (Shanghai)Ltd like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Asia Cuanon Technology (Shanghai)Ltd achieved a positive EBIT of CN¥71m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Asia Cuanon Technology (Shanghai)Ltd'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Asia Cuanon Technology (Shanghai)Ltd actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither Asia Cuanon Technology (Shanghai)Ltd's ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Asia Cuanon Technology (Shanghai)Ltd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. We've identified 4 warning signs with Asia Cuanon Technology (Shanghai)Ltd (at least 1 which is concerning) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.