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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Shenzhen Sunshine Laser & Electronics Technology Co., Ltd. (SZSE:300227) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shenzhen Sunshine Laser & Electronics Technology

What Is Shenzhen Sunshine Laser & Electronics Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Shenzhen Sunshine Laser & Electronics Technology had CN¥386.8m of debt, an increase on CN¥306.9m, over one year. However, it does have CN¥175.2m in cash offsetting this, leading to net debt of about CN¥211.6m.

How Healthy Is Shenzhen Sunshine Laser & Electronics Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Sunshine Laser & Electronics Technology had liabilities of CN¥656.0m due within 12 months and liabilities of CN¥212.9m due beyond that. Offsetting this, it had CN¥175.2m in cash and CN¥511.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥181.8m more than its cash and near-term receivables, combined.

Given Shenzhen Sunshine Laser & Electronics Technology has a market capitalization of CN¥4.00b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.0 and interest cover of 6.1 times, it seems to us that Shenzhen Sunshine Laser & Electronics Technology is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The modesty of its debt load may become crucial for Shenzhen Sunshine Laser & Electronics Technology if management cannot prevent a repeat of the 37% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shenzhen Sunshine Laser & Electronics Technology will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shenzhen Sunshine Laser & Electronics Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Shenzhen Sunshine Laser & Electronics Technology'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. Once we consider all the factors above, together, it seems to us that Shenzhen Sunshine Laser & Electronics Technology's debt is making it 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. To that end, you should be aware of the 2 warning signs we've spotted with Shenzhen Sunshine Laser & Electronics Technology .

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.