Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Sinomach Precision Industry Group Co., Ltd. (SZSE:002046) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Sinomach Precision Industry Group Carry?

The image below, which you can click on for greater detail, shows that Sinomach Precision Industry Group had debt of CN¥679.8m at the end of March 2024, a reduction from CN¥798.2m over a year. However, because it has a cash reserve of CN¥606.1m, its net debt is less, at about CN¥73.7m.

How Strong Is Sinomach Precision Industry Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sinomach Precision Industry Group had liabilities of CN¥1.18b due within 12 months and liabilities of CN¥576.2m due beyond that. Offsetting this, it had CN¥606.1m in cash and CN¥1.36b in receivables that were due within 12 months. So it actually has CN¥211.6m more liquid assets than total liabilities.

This surplus suggests that Sinomach Precision Industry Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. But either way, Sinomach Precision Industry Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sinomach Precision Industry Group has a low net debt to EBITDA ratio of only 0.18. And its EBIT easily covers its interest expense, being 13.7 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Sinomach Precision Industry Group has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sinomach Precision Industry Group'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Sinomach Precision Industry Group's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Sinomach Precision Industry Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at the bigger picture, we think Sinomach Precision Industry Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Sinomach Precision Industry Group that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

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