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 ShenZhen YUTO Packaging Technology Co., Ltd. (SZSE:002831) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does ShenZhen YUTO Packaging Technology Carry?

The chart below, which you can click on for greater detail, shows that ShenZhen YUTO Packaging Technology had CN¥5.29b in debt in June 2024; about the same as the year before. However, because it has a cash reserve of CN¥4.50b, its net debt is less, at about CN¥792.8m.

A Look At ShenZhen YUTO Packaging Technology's Liabilities

According to the last reported balance sheet, ShenZhen YUTO Packaging Technology had liabilities of CN¥8.63b due within 12 months, and liabilities of CN¥1.56b due beyond 12 months. Offsetting these obligations, it had cash of CN¥4.50b as well as receivables valued at CN¥5.03b due within 12 months. So its liabilities total CN¥653.3m more than the combination of its cash and short-term receivables.

Given ShenZhen YUTO Packaging Technology has a market capitalization of CN¥23.5b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

ShenZhen YUTO Packaging Technology's net debt is only 0.31 times its EBITDA. And its EBIT easily covers its interest expense, being 25.8 times the size. So we're pretty relaxed about its super-conservative use of debt. The good news is that ShenZhen YUTO Packaging Technology has increased its EBIT by 8.9% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ShenZhen YUTO Packaging Technology 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, ShenZhen YUTO Packaging Technology recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

ShenZhen YUTO Packaging Technology's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Overall, we don't think ShenZhen YUTO Packaging Technology is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with ShenZhen YUTO Packaging Technology .

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.

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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.