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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Hoshine Silicon Industry Co., Ltd. (SHSE:603260) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 Hoshine Silicon Industry's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Hoshine Silicon Industry had CN¥31.1b of debt, an increase on CN¥27.8b, over one year. However, because it has a cash reserve of CN¥1.55b, its net debt is less, at about CN¥29.5b.

How Strong Is Hoshine Silicon Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hoshine Silicon Industry had liabilities of CN¥31.5b due within 12 months and liabilities of CN¥23.4b due beyond that. Offsetting this, it had CN¥1.55b in cash and CN¥3.07b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥50.3b.

This deficit is considerable relative to its market capitalization of CN¥58.2b, so it does suggest shareholders should keep an eye on Hoshine Silicon Industry's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Hoshine Silicon Industry has a rather high debt to EBITDA ratio of 5.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.7 times, suggesting it can responsibly service its obligations. Shareholders should be aware that Hoshine Silicon Industry's EBIT was down 39% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hoshine Silicon Industry can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hoshine Silicon Industry burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Hoshine Silicon Industry'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. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Taking into account all the aforementioned factors, it looks like Hoshine Silicon Industry has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 learn about the 4 warning signs we've spotted with Hoshine Silicon Industry (including 2 which shouldn'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.