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.' 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. As with many other companies SonoScape Medical Corp. (SZSE:300633) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 SonoScape Medical's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 SonoScape Medical had CN¥250.0m of debt, an increase on CN¥230.5m, over one year. But it also has CN¥1.96b in cash to offset that, meaning it has CN¥1.71b net cash.

How Strong Is SonoScape Medical's Balance Sheet?

The latest balance sheet data shows that SonoScape Medical had liabilities of CN¥731.6m due within a year, and liabilities of CN¥55.7m falling due after that. Offsetting these obligations, it had cash of CN¥1.96b as well as receivables valued at CN¥200.4m due within 12 months. So it can boast CN¥1.38b more liquid assets than total liabilities.

This surplus suggests that SonoScape Medical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, SonoScape Medical boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, SonoScape Medical saw its EBIT drop by 2.1% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 SonoScape Medical'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. While SonoScape Medical 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. Over the most recent three years, SonoScape Medical recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. 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 SonoScape Medical has net cash of CN¥1.71b, as well as more liquid assets than liabilities. So we don't think SonoScape Medical's use of debt is risky. 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. Case in point: We've spotted 1 warning sign for SonoScape Medical 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.

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