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 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. As with many other companies Sinoma Science & Technology Co.,Ltd. (SZSE:002080) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Sinoma Science & TechnologyLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Sinoma Science & TechnologyLtd had debt of CN¥17.1b, up from CN¥15.0b in one year. However, it also had CN¥1.67b in cash, and so its net debt is CN¥15.4b.

A Look At Sinoma Science & TechnologyLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Sinoma Science & TechnologyLtd had liabilities of CN¥19.2b due within 12 months and liabilities of CN¥12.8b due beyond that. Offsetting these obligations, it had cash of CN¥1.67b as well as receivables valued at CN¥12.2b due within 12 months. So it has liabilities totalling CN¥18.0b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥21.9b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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 net debt to EBITDA ratio of 5.1, it's fair to say Sinoma Science & TechnologyLtd does have a significant amount of debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. Worse, Sinoma Science & TechnologyLtd's EBIT was down 64% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sinoma Science & TechnologyLtd 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Sinoma Science & TechnologyLtd 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

To be frank both Sinoma Science & TechnologyLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Sinoma Science & TechnologyLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Sinoma Science & TechnologyLtd 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.