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. Importantly, Guangdong Senssun Weighing Apparatus Group Ltd. (SZSE:002870) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Guangdong Senssun Weighing Apparatus Group's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Guangdong Senssun Weighing Apparatus Group had debt of CN¥1.89b, up from CN¥1.60b in one year. However, it does have CN¥622.6m in cash offsetting this, leading to net debt of about CN¥1.26b.

How Healthy Is Guangdong Senssun Weighing Apparatus Group's Balance Sheet?

According to the last reported balance sheet, Guangdong Senssun Weighing Apparatus Group had liabilities of CN¥3.67b due within 12 months, and liabilities of CN¥1.18b due beyond 12 months. On the other hand, it had cash of CN¥622.6m and CN¥1.21b worth of receivables due within a year. So it has liabilities totalling CN¥3.02b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥4.01b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Guangdong Senssun Weighing Apparatus Group has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.3 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Guangdong Senssun Weighing Apparatus Group's EBIT shot up like bamboo after rain, gaining 86% in the last twelve months. That'll make it easier to manage its debt. 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 Guangdong Senssun Weighing Apparatus Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Guangdong Senssun Weighing Apparatus Group's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Guangdong Senssun Weighing Apparatus Group's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Guangdong Senssun Weighing Apparatus Group'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. 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 Guangdong Senssun Weighing Apparatus Group 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.