Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Jiangsu Lopal Tech. Co., Ltd. (SHSE:603906) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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.
View our latest analysis for Jiangsu Lopal Tech
How Much Debt Does Jiangsu Lopal Tech Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2022 Jiangsu Lopal Tech had CN¥4.26b of debt, an increase on CN¥1.56b, over one year. However, it does have CN¥2.31b in cash offsetting this, leading to net debt of about CN¥1.95b.
SHSE:603906 Debt to Equity History January 9th 2023
A Look At Jiangsu Lopal Tech's Liabilities
According to the last reported balance sheet, Jiangsu Lopal Tech had liabilities of CN¥5.39b due within 12 months, and liabilities of CN¥1.49b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.31b as well as receivables valued at CN¥2.42b due within 12 months. So its liabilities total CN¥2.15b more than the combination of its cash and short-term receivables.
Given Jiangsu Lopal Tech has a market capitalization of CN¥13.7b, 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). 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).
Jiangsu Lopal Tech's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 14.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Jiangsu Lopal Tech grew its EBIT by 351% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Jiangsu Lopal Tech'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Jiangsu Lopal Tech saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Jiangsu Lopal Tech's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Jiangsu Lopal Tech can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Be aware that Jiangsu Lopal Tech is showing 3 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...
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.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. 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.
