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 Cscec Scimee Sci.&Tech. Co.,Ltd (SZSE:300425) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Cscec Scimee Sci.&Tech.Ltd Carry?

As you can see below, at the end of June 2024, Cscec Scimee Sci.&Tech.Ltd had CN¥870.2m of debt, up from CN¥803.3m a year ago. Click the image for more detail. However, it also had CN¥199.6m in cash, and so its net debt is CN¥670.7m.

How Healthy Is Cscec Scimee Sci.&Tech.Ltd's Balance Sheet?

The latest balance sheet data shows that Cscec Scimee Sci.&Tech.Ltd had liabilities of CN¥1.51b due within a year, and liabilities of CN¥497.2m falling due after that. Offsetting these obligations, it had cash of CN¥199.6m as well as receivables valued at CN¥2.02b due within 12 months. So it actually has CN¥215.1m more liquid assets than total liabilities.

This short term liquidity is a sign that Cscec Scimee Sci.&Tech.Ltd could probably pay off its debt with ease, as its balance sheet is far from stretched.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a debt to EBITDA ratio of 2.2, Cscec Scimee Sci.&Tech.Ltd uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.7 times its interest expenses harmonizes with that theme. Sadly, Cscec Scimee Sci.&Tech.Ltd's EBIT actually dropped 5.8% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Cscec Scimee Sci.&Tech.Ltd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Cscec Scimee Sci.&Tech.Ltd 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

Cscec Scimee Sci.&Tech.Ltd'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 cover its interest expense with its EBIT isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Cscec Scimee Sci.&Tech.Ltd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we've identified 2 warning signs for Cscec Scimee Sci.&Tech.Ltd (1 is significant) you should be aware of.

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.