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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Western Superconducting Technologies Co., Ltd. (SHSE:688122) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Western Superconducting Technologies Carry?

As you can see below, Western Superconducting Technologies had CN¥2.64b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥2.11b in cash, and so its net debt is CN¥533.5m.

A Look At Western Superconducting Technologies' Liabilities

We can see from the most recent balance sheet that Western Superconducting Technologies had liabilities of CN¥4.26b falling due within a year, and liabilities of CN¥1.34b due beyond that. Offsetting these obligations, it had cash of CN¥2.11b as well as receivables valued at CN¥4.00b due within 12 months. So it can boast CN¥513.6m more liquid assets than total liabilities.

Having regard to Western Superconducting Technologies' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥28.5b company is short on cash, but still worth keeping an eye on the balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Western Superconducting Technologies has a low net debt to EBITDA ratio of only 0.57. And its EBIT easily covers its interest expense, being 16.1 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Western Superconducting Technologies saw its EBIT drop by 7.3% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Western Superconducting Technologies can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Western Superconducting Technologies recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On our analysis Western Superconducting Technologies's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Western Superconducting Technologies's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example, we've discovered 2 warning signs for Western Superconducting Technologies that you should be aware of before investing here.

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.