Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Shanghai Fudan Microelectronics Group Company Limited (HKG:1385) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. 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 Fudan Microelectronics Group's Debt?

As you can see below, at the end of December 2023, Shanghai Fudan Microelectronics Group had CN¥1.48b of debt, up from CN¥54.0m a year ago. Click the image for more detail. However, it does have CN¥1.03b in cash offsetting this, leading to net debt of about CN¥445.6m.

How Healthy Is Shanghai Fudan Microelectronics Group's Balance Sheet?

The latest balance sheet data shows that Shanghai Fudan Microelectronics Group had liabilities of CN¥1.88b due within a year, and liabilities of CN¥570.3m falling due after that. On the other hand, it had cash of CN¥1.03b and CN¥1.48b worth of receivables due within a year. So it can boast CN¥66.8m more liquid assets than total liabilities.

Having regard to Shanghai Fudan Microelectronics Group's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥19.6b company is short on cash, but still worth keeping an eye on the balance sheet.

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.

Shanghai Fudan Microelectronics Group has a low net debt to EBITDA ratio of only 0.59. And its EBIT covers its interest expense a whopping 78.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Shanghai Fudan Microelectronics Group's saving grace is its low debt levels, because its EBIT has tanked 42% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shanghai Fudan Microelectronics Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shanghai Fudan Microelectronics Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shanghai Fudan Microelectronics Group's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Shanghai Fudan Microelectronics Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Fudan Microelectronics Group (of which 1 can't be ignored!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.