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.' 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. We note that Bestlink Technologies Co.,Ltd. (SHSE:603206) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Bestlink TechnologiesLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Bestlink TechnologiesLtd had CN¥749.4m of debt, an increase on CN¥145.7m, over one year. However, it does have CN¥668.3m in cash offsetting this, leading to net debt of about CN¥81.1m.

How Strong Is Bestlink TechnologiesLtd's Balance Sheet?

The latest balance sheet data shows that Bestlink TechnologiesLtd had liabilities of CN¥3.02b due within a year, and liabilities of CN¥8.28m falling due after that. Offsetting this, it had CN¥668.3m in cash and CN¥1.62b in receivables that were due within 12 months. So it has liabilities totalling CN¥748.6m more than its cash and near-term receivables, combined.

Since publicly traded Bestlink TechnologiesLtd shares are worth a total of CN¥4.75b, it seems unlikely that this level of liabilities would be a major threat. 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). 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).

Bestlink TechnologiesLtd's net debt is only 0.40 times its EBITDA. And its EBIT easily covers its interest expense, being 222 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Bestlink TechnologiesLtd's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is Bestlink TechnologiesLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Bestlink TechnologiesLtd 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.

Our View

While Bestlink TechnologiesLtd's conversion of EBIT to free cash flow has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. When we consider all the factors discussed, it seems to us that Bestlink TechnologiesLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Bestlink TechnologiesLtd (of which 1 is a bit concerning!) 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.

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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.