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 note that Gotion High-tech Co.,Ltd. (SZSE:002074) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Gotion High-techLtd's Net Debt?

As you can see below, at the end of September 2023, Gotion High-techLtd had CN¥32.5b of debt, up from CN¥20.9b a year ago. Click the image for more detail. However, it also had CN¥18.6b in cash, and so its net debt is CN¥13.9b.

How Strong Is Gotion High-techLtd's Balance Sheet?

The latest balance sheet data shows that Gotion High-techLtd had liabilities of CN¥40.3b due within a year, and liabilities of CN¥21.6b falling due after that. Offsetting this, it had CN¥18.6b in cash and CN¥14.3b in receivables that were due within 12 months. So it has liabilities totalling CN¥29.0b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥34.6b, so it does suggest shareholders should keep an eye on Gotion High-techLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gotion High-techLtd 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.

In the last year Gotion High-techLtd wasn't profitable at an EBIT level, but managed to grow its revenue by 60%, to CN¥30b. Shareholders probably have their fingers crossed that it can grow its way to profits.

Caveat Emptor

Despite the top line growth, Gotion High-techLtd still had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥169m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥11b in negative free cash flow over the last twelve months. So in short it's a really risky stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Gotion High-techLtd has 2 warning signs we think 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.