The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Sunny Optical Technology (Group) Company Limited (HKG:2382) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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, 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.

See our latest analysis for Sunny Optical Technology (Group)

What Is Sunny Optical Technology (Group)'s Debt?

As you can see below, Sunny Optical Technology (Group) had CN¥6.25b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has CN¥14.4b in cash, leading to a CN¥8.18b net cash position.

How Healthy Is Sunny Optical Technology (Group)'s Balance Sheet?

The latest balance sheet data shows that Sunny Optical Technology (Group) had liabilities of CN¥15.0b due within a year, and liabilities of CN¥2.23b falling due after that. Offsetting this, it had CN¥14.4b in cash and CN¥7.18b in receivables that were due within 12 months. So it actually has CN¥4.41b more liquid assets than total liabilities.

This surplus suggests that Sunny Optical Technology (Group) has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Sunny Optical Technology (Group) has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Sunny Optical Technology (Group)'s load is not too heavy, because its EBIT was down 44% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sunny Optical Technology (Group) can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Sunny Optical Technology (Group) may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Sunny Optical Technology (Group) recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Sunny Optical Technology (Group) has net cash of CN¥8.18b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥3.3b, being 72% of its EBIT. So we are not troubled with Sunny Optical Technology (Group)'s debt use. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Sunny Optical Technology (Group)'s earnings per share history for free.

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.