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 Shannon Semiconductor Technology Co.,Ltd. (SZSE:300475) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shannon Semiconductor TechnologyLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Shannon Semiconductor TechnologyLtd had CN¥2.23b of debt, an increase on CN¥1.96b, over one year. However, it does have CN¥1.02b in cash offsetting this, leading to net debt of about CN¥1.21b.

How Healthy Is Shannon Semiconductor TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shannon Semiconductor TechnologyLtd had liabilities of CN¥6.37b due within 12 months and liabilities of CN¥321.8m due beyond that. On the other hand, it had cash of CN¥1.02b and CN¥4.90b worth of receivables due within a year. So its liabilities total CN¥776.5m more than the combination of its cash and short-term receivables.

Given Shannon Semiconductor TechnologyLtd has a market capitalization of CN¥16.7b, 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.

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

Shannon Semiconductor TechnologyLtd's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 19.6 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Shannon Semiconductor TechnologyLtd grew its EBIT by 119% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Shannon Semiconductor TechnologyLtd'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shannon Semiconductor TechnologyLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, Shannon Semiconductor TechnologyLtd's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Shannon Semiconductor TechnologyLtd can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Shannon Semiconductor TechnologyLtd you should be aware of.

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.

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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.