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. We note that TES Touch Embedded Solutions (Xiamen) Co., Ltd. (SZSE:003019) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is TES Touch Embedded Solutions (Xiamen)'s Debt?

The image below, which you can click on for greater detail, shows that at March 2024 TES Touch Embedded Solutions (Xiamen) had debt of CN¥252.0m, up from CN¥201.9m in one year. But it also has CN¥431.8m in cash to offset that, meaning it has CN¥179.8m net cash.

How Healthy Is TES Touch Embedded Solutions (Xiamen)'s Balance Sheet?

The latest balance sheet data shows that TES Touch Embedded Solutions (Xiamen) had liabilities of CN¥770.3m due within a year, and liabilities of CN¥78.0m falling due after that. Offsetting these obligations, it had cash of CN¥431.8m as well as receivables valued at CN¥487.8m due within 12 months. So it can boast CN¥71.3m more liquid assets than total liabilities.

Having regard to TES Touch Embedded Solutions (Xiamen)'s size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥3.84b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that TES Touch Embedded Solutions (Xiamen) has more cash than debt is arguably a good indication that it can manage its debt safely.

TES Touch Embedded Solutions (Xiamen)'s EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is TES Touch Embedded Solutions (Xiamen)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. TES Touch Embedded Solutions (Xiamen) may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, TES Touch Embedded Solutions (Xiamen) recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that TES Touch Embedded Solutions (Xiamen) has net cash of CN¥179.8m, as well as more liquid assets than liabilities. The cherry on top was that in converted 84% of that EBIT to free cash flow, bringing in CN¥378m. So is TES Touch Embedded Solutions (Xiamen)'s debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that TES Touch Embedded Solutions (Xiamen) is showing 1 warning sign in our investment analysis , you should know about...

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.

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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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