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, Union Semiconductor (Hefei) Co., Ltd. (SHSE:688403) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 Union Semiconductor (Hefei)'s Net Debt?

As you can see below, at the end of March 2024, Union Semiconductor (Hefei) had CN¥307.4m of debt, up from CN¥1.98m a year ago. Click the image for more detail. However, it does have CN¥100.7m in cash offsetting this, leading to net debt of about CN¥206.6m.

How Strong Is Union Semiconductor (Hefei)'s Balance Sheet?

According to the last reported balance sheet, Union Semiconductor (Hefei) had liabilities of CN¥468.3m due within 12 months, and liabilities of CN¥118.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥100.7m as well as receivables valued at CN¥205.1m due within 12 months. So it has liabilities totalling CN¥280.4m more than its cash and near-term receivables, combined.

Of course, Union Semiconductor (Hefei) has a market capitalization of CN¥5.70b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Union Semiconductor (Hefei) has a low debt to EBITDA ratio of only 0.45. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On top of that, Union Semiconductor (Hefei) grew its EBIT by 57% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Union Semiconductor (Hefei) will need earnings to service that debt. 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Union Semiconductor (Hefei) burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Union Semiconductor (Hefei)'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 the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Union Semiconductor (Hefei) can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. To that end, you should learn about the 2 warning signs we've spotted with Union Semiconductor (Hefei) (including 1 which shouldn't be ignored) .

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