Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Lingyi iTech (Guangdong) Company (SZSE:002600) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 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. 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.

What Is Lingyi iTech (Guangdong)'s Debt?

The chart below, which you can click on for greater detail, shows that Lingyi iTech (Guangdong) had CN¥8.68b in debt in March 2024; about the same as the year before. On the flip side, it has CN¥4.22b in cash leading to net debt of about CN¥4.46b.

How Strong Is Lingyi iTech (Guangdong)'s Balance Sheet?

According to the last reported balance sheet, Lingyi iTech (Guangdong) had liabilities of CN¥11.7b due within 12 months, and liabilities of CN¥7.30b due beyond 12 months. Offsetting these obligations, it had cash of CN¥4.22b as well as receivables valued at CN¥9.37b due within 12 months. So its liabilities total CN¥5.45b more than the combination of its cash and short-term receivables.

Given Lingyi iTech (Guangdong) has a market capitalization of CN¥34.0b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Lingyi iTech (Guangdong)'s net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 13.2 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Lingyi iTech (Guangdong) if management cannot prevent a repeat of the 24% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lingyi iTech (Guangdong)'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Lingyi iTech (Guangdong)'s free cash flow amounted to 20% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Lingyi iTech (Guangdong)'s ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Lingyi iTech (Guangdong)'s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Lingyi iTech (Guangdong) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.