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.' 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 Shenzhen Senior Technology Material Co., LTD (SZSE:300568) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Shenzhen Senior Technology Material

What Is Shenzhen Senior Technology Material's Debt?

The image below, which you can click on for greater detail, shows that Shenzhen Senior Technology Material had debt of CN¥2.16b at the end of March 2022, a reduction from CN¥2.42b over a year. However, because it has a cash reserve of CN¥1.34b, its net debt is less, at about CN¥819.4m.

A Look At Shenzhen Senior Technology Material's Liabilities

We can see from the most recent balance sheet that Shenzhen Senior Technology Material had liabilities of CN¥2.05b falling due within a year, and liabilities of CN¥1.37b due beyond that. Offsetting this, it had CN¥1.34b in cash and CN¥1.24b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥838.7m.

Given Shenzhen Senior Technology Material has a market capitalization of CN¥38.8b, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenzhen Senior Technology Material has net debt of just 0.98 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.6 times, which is more than adequate. Better yet, Shenzhen Senior Technology Material grew its EBIT by 162% 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 it is future earnings, more than anything, that will determine Shenzhen Senior Technology Material'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shenzhen Senior Technology Material burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

The good news is that Shenzhen Senior Technology Material's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Shenzhen Senior Technology Material can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. To that end, you should learn about the 3 warning signs we've spotted with Shenzhen Senior Technology Material (including 1 which can't be ignored) .

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.