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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that China Leadshine Technology Co., Ltd. (SZSE:002979) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is China Leadshine Technology's Net Debt?
The chart below, which you can click on for greater detail, shows that China Leadshine Technology had CN¥431.6m in debt in September 2023; about the same as the year before. However, it does have CN¥393.5m in cash offsetting this, leading to net debt of about CN¥38.2m.
How Strong Is China Leadshine Technology's Balance Sheet?
The latest balance sheet data shows that China Leadshine Technology had liabilities of CN¥750.7m due within a year, and liabilities of CN¥215.5m falling due after that. Offsetting this, it had CN¥393.5m in cash and CN¥627.2m in receivables that were due within 12 months. So it actually has CN¥54.5m more liquid assets than total liabilities.
Having regard to China Leadshine Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥5.10b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, China Leadshine Technology has a very light debt load indeed.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
China Leadshine Technology has a low debt to EBITDA ratio of only 0.33. 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. In fact China Leadshine Technology's saving grace is its low debt levels, because its EBIT has tanked 48% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Leadshine 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Leadshine Technology reported free cash flow worth 6.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
Based on what we've seen China Leadshine Technology is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about China Leadshine Technology's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for China Leadshine Technology 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.