Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Dongguan Mentech Optical & Magnetic Co., Ltd. (SZSE:002902) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Dongguan Mentech Optical & Magnetic

How Much Debt Does Dongguan Mentech Optical & Magnetic Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Dongguan Mentech Optical & Magnetic had debt of CN¥638.2m, up from CN¥360.4m in one year. On the flip side, it has CN¥240.6m in cash leading to net debt of about CN¥397.7m.

A Look At Dongguan Mentech Optical & Magnetic's Liabilities

According to the last reported balance sheet, Dongguan Mentech Optical & Magnetic had liabilities of CN¥1.44b due within 12 months, and liabilities of CN¥241.6m due beyond 12 months. Offsetting this, it had CN¥240.6m in cash and CN¥852.5m in receivables that were due within 12 months. So its liabilities total CN¥588.2m more than the combination of its cash and short-term receivables.

Since publicly traded Dongguan Mentech Optical & Magnetic shares are worth a total of CN¥5.91b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Dongguan Mentech Optical & Magnetic's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Dongguan Mentech Optical & Magnetic had a loss before interest and tax, and actually shrunk its revenue by 5.2%, to CN¥2.2b. That's not what we would hope to see.

Caveat Emptor

Over the last twelve months Dongguan Mentech Optical & Magnetic produced an earnings before interest and tax (EBIT) loss. Indeed, it lost CN¥35m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. We would feel better if it turned its trailing twelve month loss of CN¥24m into a profit. So we do think this stock is quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Dongguan Mentech Optical & Magnetic you should be aware of.

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.