The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Wuxi DK Electronic Materials Co.,Ltd. (SZSE:300842) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Wuxi DK Electronic MaterialsLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Wuxi DK Electronic MaterialsLtd had CN¥3.89b of debt, an increase on CN¥1.96b, over one year. However, it does have CN¥2.13b in cash offsetting this, leading to net debt of about CN¥1.76b.

A Look At Wuxi DK Electronic MaterialsLtd's Liabilities

We can see from the most recent balance sheet that Wuxi DK Electronic MaterialsLtd had liabilities of CN¥6.02b falling due within a year, and liabilities of CN¥71.5m due beyond that. Offsetting these obligations, it had cash of CN¥2.13b as well as receivables valued at CN¥4.30b due within 12 months. So it can boast CN¥337.3m more liquid assets than total liabilities.

This surplus suggests that Wuxi DK Electronic MaterialsLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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.

Wuxi DK Electronic MaterialsLtd's debt is 2.6 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. Pleasingly, Wuxi DK Electronic MaterialsLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 286% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Wuxi DK Electronic MaterialsLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Wuxi DK Electronic MaterialsLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Wuxi DK Electronic MaterialsLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. Considering this range of data points, we think Wuxi DK Electronic MaterialsLtd is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example Wuxi DK Electronic MaterialsLtd has 3 warning signs (and 2 which are a bit concerning) we think you should know about.

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.