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.' 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 EmbedWay Technologies (Shanghai) Corporation (SHSE:603496) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 EmbedWay Technologies (Shanghai)'s Net Debt?

As you can see below, at the end of June 2024, EmbedWay Technologies (Shanghai) had CN¥284.4m of debt, up from CN¥239.5m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥227.1m, its net debt is less, at about CN¥57.3m.

How Healthy Is EmbedWay Technologies (Shanghai)'s Balance Sheet?

According to the last reported balance sheet, EmbedWay Technologies (Shanghai) had liabilities of CN¥478.4m due within 12 months, and liabilities of CN¥69.3m due beyond 12 months. On the other hand, it had cash of CN¥227.1m and CN¥626.8m worth of receivables due within a year. So it can boast CN¥306.1m more liquid assets than total liabilities.

This short term liquidity is a sign that EmbedWay Technologies (Shanghai) could probably pay off its debt with ease, as its balance sheet is far from stretched. Carrying virtually no net debt, EmbedWay Technologies (Shanghai) has a very light debt load indeed.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

EmbedWay Technologies (Shanghai) has a low net debt to EBITDA ratio of only 0.36. And its EBIT covers its interest expense a whopping 31.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, EmbedWay Technologies (Shanghai) grew its EBIT by 169% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine EmbedWay Technologies (Shanghai)'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, EmbedWay Technologies (Shanghai) 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

The good news is that EmbedWay Technologies (Shanghai)'s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that EmbedWay Technologies (Shanghai) takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of EmbedWay Technologies (Shanghai)'s earnings per share history for free.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.