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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shanghai V-Test Semiconductor Tech. Co., Ltd. (SHSE:688372) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Shanghai V-Test Semiconductor Tech's Debt?
As you can see below, Shanghai V-Test Semiconductor Tech had CN¥689.5m of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥362.1m in cash offsetting this, leading to net debt of about CN¥327.3m.
How Healthy Is Shanghai V-Test Semiconductor Tech's Balance Sheet?
The latest balance sheet data shows that Shanghai V-Test Semiconductor Tech had liabilities of CN¥523.0m due within a year, and liabilities of CN¥626.4m falling due after that. Offsetting this, it had CN¥362.1m in cash and CN¥337.4m in receivables that were due within 12 months. So it has liabilities totalling CN¥449.9m more than its cash and near-term receivables, combined.
Given Shanghai V-Test Semiconductor Tech has a market capitalization of CN¥6.53b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt sitting at just 1.0 times EBITDA, Shanghai V-Test Semiconductor Tech is arguably pretty conservatively geared. And it boasts interest cover of 7.2 times, which is more than adequate. It is just as well that Shanghai V-Test Semiconductor Tech's load is not too heavy, because its EBIT was down 57% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shanghai V-Test Semiconductor Tech 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, 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, Shanghai V-Test Semiconductor Tech saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both Shanghai V-Test Semiconductor Tech's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Shanghai V-Test Semiconductor Tech stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 Shanghai V-Test Semiconductor Tech you should be aware of, and 1 of them is a bit unpleasant.
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.