Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Guangdong Champion Asia Electronics Co.,Ltd. (SHSE:603386) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Guangdong Champion Asia ElectronicsLtd

What Is Guangdong Champion Asia ElectronicsLtd's Debt?

The image below, which you can click on for greater detail, shows that Guangdong Champion Asia ElectronicsLtd had debt of CN¥630.3m at the end of March 2022, a reduction from CN¥710.6m over a year. However, it also had CN¥169.3m in cash, and so its net debt is CN¥461.0m.

A Look At Guangdong Champion Asia ElectronicsLtd's Liabilities

The latest balance sheet data shows that Guangdong Champion Asia ElectronicsLtd had liabilities of CN¥1.60b due within a year, and liabilities of CN¥233.8m falling due after that. On the other hand, it had cash of CN¥169.3m and CN¥710.2m worth of receivables due within a year. So it has liabilities totalling CN¥958.8m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Guangdong Champion Asia ElectronicsLtd has a market capitalization of CN¥4.37b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt sitting at just 1.4 times EBITDA, Guangdong Champion Asia ElectronicsLtd is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.1 times the interest expense over the last year. But the bad news is that Guangdong Champion Asia ElectronicsLtd has seen its EBIT plunge 18% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Guangdong Champion Asia ElectronicsLtd'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. In the last two years, Guangdong Champion Asia ElectronicsLtd created free cash flow amounting to 7.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Guangdong Champion Asia ElectronicsLtd's struggle to grow its EBIT 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. When we consider all the factors discussed, it seems to us that Guangdong Champion Asia ElectronicsLtd 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. 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. Be aware that Guangdong Champion Asia ElectronicsLtd is showing 3 warning signs in our investment analysis , 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.