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, Fujian Torch Electron Technology Co., Ltd. (SHSE:603678) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

What Is Fujian Torch Electron Technology's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Fujian Torch Electron Technology had debt of CN¥1.45b, up from CN¥1.34b in one year. On the flip side, it has CN¥1.15b in cash leading to net debt of about CN¥300.2m.

A Look At Fujian Torch Electron Technology's Liabilities

We can see from the most recent balance sheet that Fujian Torch Electron Technology had liabilities of CN¥1.25b falling due within a year, and liabilities of CN¥1.00b due beyond that. On the other hand, it had cash of CN¥1.15b and CN¥2.13b worth of receivables due within a year. So it actually has CN¥1.03b more liquid assets than total liabilities.

This short term liquidity is a sign that Fujian Torch Electron Technology could probably pay off its debt with ease, as its balance sheet is far from stretched.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Fujian Torch Electron Technology has a low net debt to EBITDA ratio of only 0.52. And its EBIT easily covers its interest expense, being 10.7 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Fujian Torch Electron Technology's load is not too heavy, because its EBIT was down 61% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Fujian Torch Electron Technology's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Fujian Torch Electron Technology's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Fujian Torch Electron Technology's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Fujian Torch Electron Technology's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should be aware of the 2 warning signs we've spotted with Fujian Torch Electron Technology .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.