Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Tellhow Sci-Tech Co., Ltd. (SHSE:600590) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Tellhow Sci-Tech's Debt?

The image below, which you can click on for greater detail, shows that Tellhow Sci-Tech had debt of CN¥4.08b at the end of September 2023, a reduction from CN¥4.75b over a year. However, it does have CN¥1.83b in cash offsetting this, leading to net debt of about CN¥2.25b.

How Strong Is Tellhow Sci-Tech's Balance Sheet?

The latest balance sheet data shows that Tellhow Sci-Tech had liabilities of CN¥6.18b due within a year, and liabilities of CN¥2.54b falling due after that. Offsetting this, it had CN¥1.83b in cash and CN¥4.79b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.10b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Tellhow Sci-Tech has a market capitalization of CN¥4.02b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Tellhow Sci-Tech shareholders face the double whammy of a high net debt to EBITDA ratio (8.8), and fairly weak interest coverage, since EBIT is just 1.1 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Tellhow Sci-Tech is that it turned last year's EBIT loss into a gain of CN¥178m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tellhow Sci-Tech will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last year, Tellhow Sci-Tech 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

On the face of it, Tellhow Sci-Tech's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Tellhow Sci-Tech's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 2 warning signs for Tellhow Sci-Tech that you should be aware of.

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.