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.' 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. Importantly, Sinoma Science & Technology Co.,Ltd. (SZSE:002080) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sinoma Science & TechnologyLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Sinoma Science & TechnologyLtd had CN¥15.4b of debt, an increase on CN¥12.5b, over one year. On the flip side, it has CN¥1.77b in cash leading to net debt of about CN¥13.7b.

A Look At Sinoma Science & TechnologyLtd's Liabilities

We can see from the most recent balance sheet that Sinoma Science & TechnologyLtd had liabilities of CN¥18.8b falling due within a year, and liabilities of CN¥12.6b due beyond that. Offsetting these obligations, it had cash of CN¥1.77b as well as receivables valued at CN¥13.3b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥16.3b.

This deficit is considerable relative to its market capitalization of CN¥19.3b, so it does suggest shareholders should keep an eye on Sinoma Science & TechnologyLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sinoma Science & TechnologyLtd's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 6.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that Sinoma Science & TechnologyLtd's EBIT was down 24% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sinoma Science & TechnologyLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sinoma Science & TechnologyLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Sinoma Science & TechnologyLtd's conversion of EBIT to free cash flow 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 on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Sinoma Science & TechnologyLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 4 warning signs we've spotted with Sinoma Science & TechnologyLtd .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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