Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Ningbo Kangqiang Electronics Co., Ltd (SZSE:002119) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Ningbo Kangqiang Electronics's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Ningbo Kangqiang Electronics had CN¥677.5m of debt, an increase on CN¥439.7m, over one year. However, because it has a cash reserve of CN¥188.0m, its net debt is less, at about CN¥489.5m.

How Strong Is Ningbo Kangqiang Electronics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ningbo Kangqiang Electronics had liabilities of CN¥951.4m due within 12 months and liabilities of CN¥102.9m due beyond that. On the other hand, it had cash of CN¥188.0m and CN¥519.4m worth of receivables due within a year. So it has liabilities totalling CN¥347.0m more than its cash and near-term receivables, combined.

Of course, Ningbo Kangqiang Electronics has a market capitalization of CN¥3.95b, 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.

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.

Ningbo Kangqiang Electronics's net debt is 4.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 15.4 is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that Ningbo Kangqiang Electronics's EBIT was down 78% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Ningbo Kangqiang Electronics will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Ningbo Kangqiang Electronics recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Based on what we've seen Ningbo Kangqiang Electronics is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Considering this range of data points, we think Ningbo Kangqiang Electronics is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Ningbo Kangqiang Electronics you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.