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. Importantly, Shenzhen FRD Science & Technology Co., Ltd. (SZSE:300602) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Shenzhen FRD Science & Technology's Debt?

The chart below, which you can click on for greater detail, shows that Shenzhen FRD Science & Technology had CN¥1.50b in debt in September 2024; about the same as the year before. However, it does have CN¥1.37b in cash offsetting this, leading to net debt of about CN¥127.0m.

How Strong Is Shenzhen FRD Science & Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen FRD Science & Technology had liabilities of CN¥2.91b due within 12 months and liabilities of CN¥792.4m due beyond that. Offsetting these obligations, it had cash of CN¥1.37b as well as receivables valued at CN¥2.16b due within 12 months. So it has liabilities totalling CN¥163.9m more than its cash and near-term receivables, combined.

Having regard to Shenzhen FRD Science & Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥11.9b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Shenzhen FRD Science & Technology has a very light debt load indeed.

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.

Shenzhen FRD Science & Technology's net debt is only 0.32 times its EBITDA. And its EBIT easily covers its interest expense, being 11.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Shenzhen FRD Science & Technology grew its EBIT by 148% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shenzhen FRD Science & Technology 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Shenzhen FRD Science & Technology 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

Happily, Shenzhen FRD Science & Technology's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Shenzhen FRD Science & Technology can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Be aware that Shenzhen FRD Science & Technology is showing 1 warning sign in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.