Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Xiamen Faratronic Co., Ltd. (SHSE:600563) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Xiamen Faratronic's Debt?

The image below, which you can click on for greater detail, shows that Xiamen Faratronic had debt of CN¥18.3m at the end of December 2023, a reduction from CN¥37.0m over a year. But on the other hand it also has CN¥1.11b in cash, leading to a CN¥1.09b net cash position.

How Healthy Is Xiamen Faratronic's Balance Sheet?

According to the last reported balance sheet, Xiamen Faratronic had liabilities of CN¥1.37b due within 12 months, and liabilities of CN¥183.6m due beyond 12 months. On the other hand, it had cash of CN¥1.11b and CN¥1.65b worth of receivables due within a year. So it actually has CN¥1.20b more liquid assets than total liabilities.

This surplus suggests that Xiamen Faratronic has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Xiamen Faratronic has more cash than debt is arguably a good indication that it can manage its debt safely.

The good news is that Xiamen Faratronic has increased its EBIT by 4.7% over twelve months, which should ease any concerns about debt repayment. 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 Xiamen Faratronic'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Xiamen Faratronic may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Xiamen Faratronic produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Xiamen Faratronic has CN¥1.09b in net cash and a decent-looking balance sheet. So we don't think Xiamen Faratronic's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Xiamen Faratronic's earnings per share history for free.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.