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.' 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 Caihong Display Devices Co.,Ltd. (SHSE:600707) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Caihong Display DevicesLtd Carry?

The image below, which you can click on for greater detail, shows that Caihong Display DevicesLtd had debt of CN¥14.3b at the end of March 2024, a reduction from CN¥17.3b over a year. However, it also had CN¥6.22b in cash, and so its net debt is CN¥8.09b.

A Look At Caihong Display DevicesLtd's Liabilities

We can see from the most recent balance sheet that Caihong Display DevicesLtd had liabilities of CN¥10.6b falling due within a year, and liabilities of CN¥7.64b due beyond that. Offsetting this, it had CN¥6.22b in cash and CN¥1.99b in receivables that were due within 12 months. So it has liabilities totalling CN¥10.1b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Caihong Display DevicesLtd is worth CN¥25.7b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Caihong Display DevicesLtd's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 4.7 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. We also note that Caihong Display DevicesLtd improved its EBIT from a last year's loss to a positive CN¥1.4b. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Caihong Display DevicesLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Caihong Display DevicesLtd actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

When it comes to the balance sheet, the standout positive for Caihong Display DevicesLtd was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its interest cover makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Caihong Display DevicesLtd is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Caihong Display DevicesLtd has 1 warning sign we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.