David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Colorlight Cloud Tech Ltd (SZSE:301391) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Colorlight Cloud Tech's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2023 Colorlight Cloud Tech had debt of CN¥125.5m, up from CN¥56.6m in one year. But on the other hand it also has CN¥1.78b in cash, leading to a CN¥1.65b net cash position.
How Strong Is Colorlight Cloud Tech's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Colorlight Cloud Tech had liabilities of CN¥553.0m due within 12 months and liabilities of CN¥32.1m due beyond that. Offsetting these obligations, it had cash of CN¥1.78b as well as receivables valued at CN¥514.2m due within 12 months. So it can boast CN¥1.71b more liquid assets than total liabilities.
This excess liquidity suggests that Colorlight Cloud Tech is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Colorlight Cloud Tech has more cash than debt is arguably a good indication that it can manage its debt safely.
Fortunately, Colorlight Cloud Tech grew its EBIT by 8.0% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Colorlight Cloud Tech's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Colorlight Cloud Tech may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Colorlight Cloud Tech reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Summing Up
While it is always sensible to investigate a company's debt, in this case Colorlight Cloud Tech has CN¥1.65b in net cash and a decent-looking balance sheet. On top of that, it increased its EBIT by 8.0% in the last twelve months. So we don't have any problem with Colorlight Cloud Tech's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Colorlight Cloud Tech that 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.