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. We note that Suzhou Electrical Apparatus Science Academy Co., Ltd. (SZSE:300215) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Suzhou Electrical Apparatus Science Academy's Debt?

The image below, which you can click on for greater detail, shows that Suzhou Electrical Apparatus Science Academy had debt of CN¥560.4m at the end of March 2024, a reduction from CN¥735.7m over a year. However, it also had CN¥330.9m in cash, and so its net debt is CN¥229.5m.

How Strong Is Suzhou Electrical Apparatus Science Academy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Suzhou Electrical Apparatus Science Academy had liabilities of CN¥404.3m due within 12 months and liabilities of CN¥382.1m due beyond that. On the other hand, it had cash of CN¥330.9m and CN¥93.8m worth of receivables due within a year. So it has liabilities totalling CN¥361.7m more than its cash and near-term receivables, combined.

Given Suzhou Electrical Apparatus Science Academy has a market capitalization of CN¥4.41b, 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).

While Suzhou Electrical Apparatus Science Academy's low debt to EBITDA ratio of 0.65 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that Suzhou Electrical Apparatus Science Academy's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Suzhou Electrical Apparatus Science Academy's earnings that will influence how the balance sheet holds up in the future. 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Suzhou Electrical Apparatus Science Academy actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Suzhou Electrical Apparatus Science Academy's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its interest cover. Looking at the bigger picture, we think Suzhou Electrical Apparatus Science Academy's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Suzhou Electrical Apparatus Science Academy is showing 3 warning signs in our investment analysis , and 2 of those can't be ignored...

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.