Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Xiamen Leading Optics Co., Ltd. (SHSE:605118) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Xiamen Leading Optics's Net Debt?

As you can see below, at the end of September 2024, Xiamen Leading Optics had CN¥99.7m of debt, up from CN¥14.0m a year ago. Click the image for more detail. However, it does have CN¥590.8m in cash offsetting this, leading to net cash of CN¥491.1m.

How Healthy Is Xiamen Leading Optics' Balance Sheet?

According to the last reported balance sheet, Xiamen Leading Optics had liabilities of CN¥241.5m due within 12 months, and liabilities of CN¥39.7m due beyond 12 months. Offsetting this, it had CN¥590.8m in cash and CN¥116.7m in receivables that were due within 12 months. So it can boast CN¥426.4m more liquid assets than total liabilities.

This short term liquidity is a sign that Xiamen Leading Optics could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Xiamen Leading Optics boasts net cash, so it's fair to say it does not have a heavy debt load!

Also positive, Xiamen Leading Optics grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xiamen Leading Optics 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. While Xiamen Leading Optics has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Xiamen Leading Optics recorded free cash flow worth a fulsome 80% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Xiamen Leading Optics has net cash of CN¥491.1m, as well as more liquid assets than liabilities. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in CN¥182m. So we don't think Xiamen Leading Optics's use of debt is risky. 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 2 warning signs for Xiamen Leading Optics (1 doesn't sit too well with us) 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.