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 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 Caihong Display Devices Co.,Ltd. (SHSE:600707) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Caihong Display DevicesLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Caihong Display DevicesLtd had CN¥13.5b of debt in September 2024, down from CN¥15.7b, one year before. However, because it has a cash reserve of CN¥7.33b, its net debt is less, at about CN¥6.18b.

A Look At Caihong Display DevicesLtd's Liabilities

We can see from the most recent balance sheet that Caihong Display DevicesLtd had liabilities of CN¥9.47b falling due within a year, and liabilities of CN¥9.74b due beyond that. Offsetting this, it had CN¥7.33b in cash and CN¥2.30b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.59b.

While this might seem like a lot, it is not so bad since Caihong Display DevicesLtd has a market capitalization of CN¥27.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

While Caihong Display DevicesLtd's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.6 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Caihong Display DevicesLtd improved its EBIT from a last year's loss to a positive CN¥1.4b. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Caihong Display DevicesLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the most recent year, Caihong Display DevicesLtd recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Caihong Display DevicesLtd's conversion of EBIT to free cash flow was a real positive on this analysis, as was its net debt to EBITDA. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Caihong Display DevicesLtd is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Caihong Display DevicesLtd you should know about.

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.