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 can see that Wedge Industrial Co.,Ltd. (SZSE:000534) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Wedge IndustrialLtd's Debt?

As you can see below, at the end of June 2024, Wedge IndustrialLtd had CN¥1.34b of debt, up from CN¥631.3m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥142.0m, its net debt is less, at about CN¥1.20b.

How Strong Is Wedge IndustrialLtd's Balance Sheet?

The latest balance sheet data shows that Wedge IndustrialLtd had liabilities of CN¥744.0m due within a year, and liabilities of CN¥1.35b falling due after that. Offsetting this, it had CN¥142.0m in cash and CN¥412.6m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.54b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Wedge IndustrialLtd is worth CN¥4.53b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Wedge IndustrialLtd's debt is 5.0 times its EBITDA, and its EBIT cover its interest expense 6.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Wedge IndustrialLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. 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 Wedge IndustrialLtd'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Wedge IndustrialLtd saw substantial negative free cash flow, in total. 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

Wedge IndustrialLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. Taking the abovementioned factors together we do think Wedge IndustrialLtd's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Wedge IndustrialLtd (at least 2 which are a bit unpleasant) , and understanding them should be part of your investment process.

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.