Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Winall Hi-tech Seed Co., Ltd. (SZSE:300087) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Winall Hi-tech Seed Carry?

As you can see below, at the end of March 2024, Winall Hi-tech Seed had CN¥1.51b of debt, up from CN¥791.9m a year ago. Click the image for more detail. However, it does have CN¥1.13b in cash offsetting this, leading to net debt of about CN¥381.9m.

A Look At Winall Hi-tech Seed's Liabilities

The latest balance sheet data shows that Winall Hi-tech Seed had liabilities of CN¥2.87b due within a year, and liabilities of CN¥737.8m falling due after that. Offsetting this, it had CN¥1.13b in cash and CN¥696.4m in receivables that were due within 12 months. So its liabilities total CN¥1.78b more than the combination of its cash and short-term receivables.

Winall Hi-tech Seed has a market capitalization of CN¥7.56b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Winall Hi-tech Seed has a low net debt to EBITDA ratio of only 0.96. And its EBIT easily covers its interest expense, being 10.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Winall Hi-tech Seed grew its EBIT at 13% over the last year, further increasing its ability to manage debt. 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 Winall Hi-tech Seed'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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Winall Hi-tech Seed created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Winall Hi-tech Seed's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. Considering this range of data points, we think Winall Hi-tech Seed is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Winall Hi-tech Seed (1 can't be ignored) 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.