Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Shenzhen Tianyuan DIC Information Technology Co., Ltd. (SZSE:300047) makes use of debt. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Shenzhen Tianyuan DIC Information Technology Carry?

You can click the graphic below for the historical numbers, but it shows that Shenzhen Tianyuan DIC Information Technology had CN¥1.61b of debt in September 2023, down from CN¥1.73b, one year before. However, it also had CN¥134.3m in cash, and so its net debt is CN¥1.47b.

A Look At Shenzhen Tianyuan DIC Information Technology's Liabilities

Zooming in on the latest balance sheet data, we can see that Shenzhen Tianyuan DIC Information Technology had liabilities of CN¥2.25b due within 12 months and liabilities of CN¥127.5m due beyond that. Offsetting this, it had CN¥134.3m in cash and CN¥1.75b in receivables that were due within 12 months. So it has liabilities totalling CN¥497.7m more than its cash and near-term receivables, combined.

Given Shenzhen Tianyuan DIC Information Technology has a market capitalization of CN¥4.81b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 39.6 hit our confidence in Shenzhen Tianyuan DIC Information Technology like a one-two punch to the gut. The debt burden here is substantial. Even worse, Shenzhen Tianyuan DIC Information Technology saw its EBIT tank 29% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shenzhen Tianyuan DIC Information Technology 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shenzhen Tianyuan DIC Information Technology saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Shenzhen Tianyuan DIC Information Technology's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Overall, it seems to us that Shenzhen Tianyuan DIC Information Technology's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 3 warning signs for Shenzhen Tianyuan DIC Information Technology (of which 2 are potentially serious!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.