Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Rainbow Digital Commercial Co., Ltd. (SZSE:002419) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Rainbow Digital Commercial Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Rainbow Digital Commercial had CN¥390.2m of debt, an increase on none, over one year. However, its balance sheet shows it holds CN¥4.49b in cash, so it actually has CN¥4.10b net cash.

How Strong Is Rainbow Digital Commercial's Balance Sheet?

We can see from the most recent balance sheet that Rainbow Digital Commercial had liabilities of CN¥10.8b falling due within a year, and liabilities of CN¥12.0b due beyond that. Offsetting these obligations, it had cash of CN¥4.49b as well as receivables valued at CN¥281.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.0b.

The deficiency here weighs heavily on the CN¥5.82b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Rainbow Digital Commercial would probably need a major re-capitalization if its creditors were to demand repayment. Given that Rainbow Digital Commercial has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

Unfortunately, Rainbow Digital Commercial's EBIT flopped 18% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Rainbow Digital Commercial can strengthen its balance sheet over time. 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. While Rainbow Digital Commercial has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Rainbow Digital Commercial actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

Although Rainbow Digital Commercial's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥4.10b. The cherry on top was that in converted 1,701% of that EBIT to free cash flow, bringing in CN¥1.9b. Despite the cash, we do find Rainbow Digital Commercial's level of total liabilities concerning, so we're not particularly comfortable with the stock. 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 instance, we've identified 2 warning signs for Rainbow Digital Commercial that you should be aware of.

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.