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 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 KINGSEMI Co., Ltd. (SHSE:688037) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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 KINGSEMI's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 KINGSEMI had debt of CN¥1.04b, up from CN¥505.8m in one year. However, it also had CN¥997.9m in cash, and so its net debt is CN¥45.1m.

A Look At KINGSEMI's Liabilities

According to the last reported balance sheet, KINGSEMI had liabilities of CN¥1.31b due within 12 months, and liabilities of CN¥834.2m due beyond 12 months. Offsetting this, it had CN¥997.9m in cash and CN¥470.2m in receivables that were due within 12 months. So it has liabilities totalling CN¥680.3m more than its cash and near-term receivables, combined.

Of course, KINGSEMI has a market capitalization of CN¥12.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, KINGSEMI has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

KINGSEMI's net debt is only 0.31 times its EBITDA. And its EBIT easily covers its interest expense, being 18.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for KINGSEMI if management cannot prevent a repeat of the 55% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if KINGSEMI can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, KINGSEMI 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

While KINGSEMI's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. When we consider all the factors discussed, it seems to us that KINGSEMI is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example KINGSEMI has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.