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. As with many other companies Chengdu Xuguang Electronics Co., Ltd. (SHSE:600353) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Chengdu Xuguang Electronics Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Chengdu Xuguang Electronics had debt of CN¥307.4m, up from CN¥253.2m in one year. However, it also had CN¥300.0m in cash, and so its net debt is CN¥7.46m.

How Healthy Is Chengdu Xuguang Electronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chengdu Xuguang Electronics had liabilities of CN¥876.3m due within 12 months and liabilities of CN¥263.6m due beyond that. Offsetting these obligations, it had cash of CN¥300.0m as well as receivables valued at CN¥1.25b due within 12 months. So it can boast CN¥410.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Chengdu Xuguang Electronics could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, Chengdu Xuguang Electronics has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With debt at a measly 0.042 times EBITDA and EBIT covering interest a whopping 17.0 times, it's clear that Chengdu Xuguang Electronics is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. In addition to that, we're happy to report that Chengdu Xuguang Electronics has boosted its EBIT by 45%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chengdu Xuguang Electronics's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Chengdu Xuguang Electronics 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

The good news is that Chengdu Xuguang Electronics's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Chengdu Xuguang Electronics takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in Chengdu Xuguang Electronics, you may well want to click here to check an interactive graph of its earnings per share history.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.