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. Importantly, CETC Chips Technology Inc. (SHSE:600877) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is CETC Chips Technology's Net Debt?
As you can see below, at the end of September 2023, CETC Chips Technology had CN¥60.1m of debt, up from none a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥814.5m in cash, so it actually has CN¥754.4m net cash.
How Strong Is CETC Chips Technology's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that CETC Chips Technology had liabilities of CN¥547.0m due within 12 months and liabilities of CN¥10.2m due beyond that. Offsetting this, it had CN¥814.5m in cash and CN¥1.08b in receivables that were due within 12 months. So it can boast CN¥1.34b more liquid assets than total liabilities.
This surplus suggests that CETC Chips Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that CETC Chips Technology has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for CETC Chips Technology if management cannot prevent a repeat of the 21% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since CETC Chips Technology 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. CETC Chips Technology 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, CETC Chips Technology recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that CETC Chips Technology has net cash of CN¥754.4m, as well as more liquid assets than liabilities. So we don't have any problem with CETC Chips Technology'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. Case in point: We've spotted 1 warning sign for CETC Chips Technology you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.