David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies VSTECS Holdings Limited (HKG:856) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is VSTECS Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 VSTECS Holdings had HK$9.55b of debt, an increase on HK$8.07b, over one year. However, it does have HK$4.52b in cash offsetting this, leading to net debt of about HK$5.03b.

How Healthy Is VSTECS Holdings' Balance Sheet?

We can see from the most recent balance sheet that VSTECS Holdings had liabilities of HK$26.7b falling due within a year, and liabilities of HK$215.6m due beyond that. On the other hand, it had cash of HK$4.52b and HK$17.7b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$4.68b.

This deficit is considerable relative to its market capitalization of HK$7.05b, so it does suggest shareholders should keep an eye on VSTECS Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

VSTECS Holdings has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, VSTECS Holdings's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 VSTECS Holdings's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, VSTECS Holdings reported free cash flow worth 16% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On this analysis VSTECS Holdings's conversion of EBIT to free cash flow and net debt to EBITDA both make us a little nervous. But at least its EBIT growth rate is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making VSTECS Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for VSTECS Holdings (1 is a bit concerning!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.