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.' 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 note that Wenzhou Yihua Connector Co., Ltd. (SZSE:002897) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Wenzhou Yihua Connector Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Wenzhou Yihua Connector had debt of CN¥2.33b, up from CN¥1.91b in one year. On the flip side, it has CN¥649.3m in cash leading to net debt of about CN¥1.68b.

A Look At Wenzhou Yihua Connector's Liabilities

We can see from the most recent balance sheet that Wenzhou Yihua Connector had liabilities of CN¥2.39b falling due within a year, and liabilities of CN¥992.5m due beyond that. On the other hand, it had cash of CN¥649.3m and CN¥1.17b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.56b.

This deficit isn't so bad because Wenzhou Yihua Connector is worth CN¥5.81b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Wenzhou Yihua Connector shareholders face the double whammy of a high net debt to EBITDA ratio (5.9), and fairly weak interest coverage, since EBIT is just 1.4 times the interest expense. The debt burden here is substantial. Even worse, Wenzhou Yihua Connector saw its EBIT tank 43% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Wenzhou Yihua Connector'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.

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, Wenzhou Yihua Connector 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

To be frank both Wenzhou Yihua Connector'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. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Wenzhou Yihua Connector to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Wenzhou Yihua Connector (1 is a bit unpleasant) 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.