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 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, Phenix Optical Company Limited (SHSE:600071) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Phenix Optical's Net Debt?

As you can see below, at the end of September 2023, Phenix Optical had CN¥700.7m of debt, up from CN¥535.5m a year ago. Click the image for more detail. However, it does have CN¥187.6m in cash offsetting this, leading to net debt of about CN¥513.1m.

How Healthy Is Phenix Optical's Balance Sheet?

We can see from the most recent balance sheet that Phenix Optical had liabilities of CN¥1.10b falling due within a year, and liabilities of CN¥297.8m due beyond that. Offsetting this, it had CN¥187.6m in cash and CN¥654.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥557.1m.

Of course, Phenix Optical has a market capitalization of CN¥5.21b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Phenix Optical will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Phenix Optical's revenue was pretty flat, and it made a negative EBIT. While that's not too bad, we'd prefer see growth.

Caveat Emptor

Importantly, Phenix Optical had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥43m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled CN¥8.6m in negative free cash flow over the last twelve months. So suffice it to say we do consider the stock to be 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Phenix Optical 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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