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.' 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. We note that Skyworth Digital Co., Ltd. (SZSE:000810) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Skyworth Digital's Net Debt?

As you can see below, at the end of March 2024, Skyworth Digital had CN¥1.08b of debt, up from CN¥640.5m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥3.51b in cash, so it actually has CN¥2.42b net cash.

How Strong Is Skyworth Digital's Balance Sheet?

We can see from the most recent balance sheet that Skyworth Digital had liabilities of CN¥4.64b falling due within a year, and liabilities of CN¥194.3m due beyond that. On the other hand, it had cash of CN¥3.51b and CN¥3.58b worth of receivables due within a year. So it actually has CN¥2.26b more liquid assets than total liabilities.

This excess liquidity suggests that Skyworth Digital is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Skyworth Digital has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Skyworth Digital's load is not too heavy, because its EBIT was down 22% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Skyworth Digital can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Skyworth Digital 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. During the last three years, Skyworth Digital produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Skyworth Digital has net cash of CN¥2.42b, as well as more liquid assets than liabilities. The cherry on top was that in converted 67% of that EBIT to free cash flow, bringing in CN¥30m. So we are not troubled with Skyworth Digital's debt use. 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. We've identified 1 warning sign with Skyworth Digital , and understanding them should be part of your investment process.

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.

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