The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We note that Ningbo KBE Electrical Technology Co.,Ltd. (SZSE:300863) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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 Ningbo KBE Electrical TechnologyLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Ningbo KBE Electrical TechnologyLtd had CN¥1.55b of debt, an increase on CN¥1.11b, over one year. On the flip side, it has CN¥578.7m in cash leading to net debt of about CN¥966.9m.

How Healthy Is Ningbo KBE Electrical TechnologyLtd's Balance Sheet?

According to the last reported balance sheet, Ningbo KBE Electrical TechnologyLtd had liabilities of CN¥1.24b due within 12 months, and liabilities of CN¥525.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥578.7m as well as receivables valued at CN¥1.13b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥64.7m.

This state of affairs indicates that Ningbo KBE Electrical TechnologyLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥4.58b company is short on cash, but still worth keeping an eye on the balance sheet.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Ningbo KBE Electrical TechnologyLtd's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 6.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. If Ningbo KBE Electrical TechnologyLtd can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. 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 Ningbo KBE Electrical TechnologyLtd'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ningbo KBE Electrical TechnologyLtd burned a lot of cash. 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

Ningbo KBE Electrical TechnologyLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. We think that Ningbo KBE Electrical TechnologyLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example Ningbo KBE Electrical TechnologyLtd has 3 warning signs (and 2 which are potentially serious) we think you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com