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.' 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 SHENZHEN TOPRAYSOLAR Co.,Ltd. (SZSE:002218) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does SHENZHEN TOPRAYSOLARLtd Carry?

The image below, which you can click on for greater detail, shows that at March 2024 SHENZHEN TOPRAYSOLARLtd had debt of CN¥1.91b, up from CN¥1.39b in one year. However, because it has a cash reserve of CN¥770.8m, its net debt is less, at about CN¥1.13b.

A Look At SHENZHEN TOPRAYSOLARLtd's Liabilities

We can see from the most recent balance sheet that SHENZHEN TOPRAYSOLARLtd had liabilities of CN¥877.7m falling due within a year, and liabilities of CN¥1.73b due beyond that. Offsetting these obligations, it had cash of CN¥770.8m as well as receivables valued at CN¥1.40b due within 12 months. So it has liabilities totalling CN¥444.9m more than its cash and near-term receivables, combined.

Given SHENZHEN TOPRAYSOLARLtd has a market capitalization of CN¥3.96b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

While we wouldn't worry about SHENZHEN TOPRAYSOLARLtd's net debt to EBITDA ratio of 3.2, we think its super-low interest cover of 1.2 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, SHENZHEN TOPRAYSOLARLtd's EBIT was down 68% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SHENZHEN TOPRAYSOLARLtd's earnings that will influence how the balance sheet holds up in the future. 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.

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. Over the last three years, SHENZHEN TOPRAYSOLARLtd reported free cash flow worth 4.6% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, SHENZHEN TOPRAYSOLARLtd's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Overall, we think it's fair to say that SHENZHEN TOPRAYSOLARLtd has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 instance, we've identified 4 warning signs for SHENZHEN TOPRAYSOLARLtd (2 are significant) you should be aware of.

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.

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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.

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