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.' 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 Sichuan Furong Technology Co., Ltd. (SHSE:603327) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sichuan Furong Technology

What Is Sichuan Furong Technology's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Sichuan Furong Technology had debt of CN¥812.4m, up from CN¥216.1m in one year. However, it also had CN¥761.1m in cash, and so its net debt is CN¥51.3m.

A Look At Sichuan Furong Technology's Liabilities

Zooming in on the latest balance sheet data, we can see that Sichuan Furong Technology had liabilities of CN¥498.1m due within 12 months and liabilities of CN¥843.3m due beyond that. Offsetting these obligations, it had cash of CN¥761.1m as well as receivables valued at CN¥457.6m due within 12 months. So it has liabilities totalling CN¥122.7m more than its cash and near-term receivables, combined.

Having regard to Sichuan Furong Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥6.74b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Sichuan Furong Technology has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sichuan Furong Technology has a low debt to EBITDA ratio of only 0.15. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. On the other hand, Sichuan Furong Technology's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sichuan Furong Technology can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Sichuan Furong Technology recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Sichuan Furong Technology's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Sichuan Furong Technology's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example Sichuan Furong Technology has 2 warning signs (and 1 which is concerning) we think you should know about.

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.