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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Raytron Technology Co.,Ltd. (SHSE:688002) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Raytron TechnologyLtd Carry?

You can click the graphic below for the historical numbers, but it shows that Raytron TechnologyLtd had CN¥1.58b of debt in September 2024, down from CN¥1.78b, one year before. However, it also had CN¥1.08b in cash, and so its net debt is CN¥502.8m.

How Healthy Is Raytron TechnologyLtd's Balance Sheet?

We can see from the most recent balance sheet that Raytron TechnologyLtd had liabilities of CN¥1.69b falling due within a year, and liabilities of CN¥1.66b due beyond that. On the other hand, it had cash of CN¥1.08b and CN¥1.56b worth of receivables due within a year. So it has liabilities totalling CN¥705.7m more than its cash and near-term receivables, combined.

Since publicly traded Raytron TechnologyLtd shares are worth a total of CN¥21.6b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Raytron TechnologyLtd has a low net debt to EBITDA ratio of only 0.73. And its EBIT covers its interest expense a whopping 18.6 times over. So we're pretty relaxed about its super-conservative use of debt. While Raytron TechnologyLtd doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Raytron 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 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. During the last three years, Raytron 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

Based on what we've seen Raytron TechnologyLtd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Raytron TechnologyLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Raytron TechnologyLtd that 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.