David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Shenzhen Minglida Precision Technology Co., Ltd. (SZSE:301268) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Shenzhen Minglida Precision Technology's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Shenzhen Minglida Precision Technology had debt of CN¥1.48b, up from CN¥584.4m in one year. On the flip side, it has CN¥1.47b in cash leading to net debt of about CN¥13.9m.

How Strong Is Shenzhen Minglida Precision Technology's Balance Sheet?

The latest balance sheet data shows that Shenzhen Minglida Precision Technology had liabilities of CN¥1.98b due within a year, and liabilities of CN¥1.22b falling due after that. Offsetting these obligations, it had cash of CN¥1.47b as well as receivables valued at CN¥1.25b due within 12 months. So it has liabilities totalling CN¥478.2m more than its cash and near-term receivables, combined.

Of course, Shenzhen Minglida Precision Technology has a market capitalization of CN¥7.42b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Shenzhen Minglida Precision Technology has a very light debt load indeed.

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.

With debt at a measly 0.024 times EBITDA and EBIT covering interest a whopping 15.3 times, it's clear that Shenzhen Minglida Precision Technology is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. On top of that, Shenzhen Minglida Precision Technology grew its EBIT by 65% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shenzhen Minglida Precision Technology'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shenzhen Minglida Precision Technology 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 Shenzhen Minglida Precision Technology'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. When we consider the range of factors above, it looks like Shenzhen Minglida Precision Technology is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. We've identified 2 warning signs with Shenzhen Minglida Precision Technology (at least 1 which is significant) , and understanding them should be part of your investment process.

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.