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.' 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. We can see that Xiamen Leading Optics Co., Ltd. (SHSE:605118) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Xiamen Leading Optics Carry?

The image below, which you can click on for greater detail, shows that Xiamen Leading Optics had debt of CN¥11.7m at the end of March 2024, a reduction from CN¥14.8m over a year. However, its balance sheet shows it holds CN¥377.8m in cash, so it actually has CN¥366.1m net cash.

How Strong Is Xiamen Leading Optics' Balance Sheet?

According to the last reported balance sheet, Xiamen Leading Optics had liabilities of CN¥120.0m due within 12 months, and liabilities of CN¥47.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥377.8m as well as receivables valued at CN¥104.0m due within 12 months. So it can boast CN¥314.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Xiamen Leading Optics could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Xiamen Leading Optics boasts net cash, so it's fair to say it does not have a heavy debt load!

Also positive, Xiamen Leading Optics grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xiamen Leading Optics 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Xiamen Leading Optics has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Xiamen Leading Optics recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Xiamen Leading Optics has CN¥366.1m in net cash and a decent-looking balance sheet. And we liked the look of last year's 25% year-on-year EBIT growth. So we don't think Xiamen Leading Optics's use of debt is risky. 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. For example Xiamen Leading Optics has 3 warning signs (and 1 which is concerning) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.