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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Traffic Control Technology Co., Ltd. (SHSE:688015) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Traffic Control Technology

What Is Traffic Control Technology's Net Debt?

As you can see below, at the end of March 2022, Traffic Control Technology had CN¥44.3m of debt, up from CN¥33.8m a year ago. Click the image for more detail. But it also has CN¥1.83b in cash to offset that, meaning it has CN¥1.78b net cash.

A Look At Traffic Control Technology's Liabilities

According to the last reported balance sheet, Traffic Control Technology had liabilities of CN¥2.47b due within 12 months, and liabilities of CN¥304.8m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.83b as well as receivables valued at CN¥1.43b due within 12 months. So it actually has CN¥486.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Traffic Control Technology could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Traffic Control Technology has more cash than debt is arguably a good indication that it can manage its debt safely.

Also positive, Traffic Control Technology grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Traffic Control Technology can strengthen its balance sheet over time. 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. While Traffic Control Technology has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Traffic Control Technology's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Traffic Control Technology has CN¥1.78b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 24% over the last year. So is Traffic Control Technology's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 3 warning signs for Traffic Control Technology (1 shouldn't be ignored) you should be aware of.

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.