David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 can see that Hangzhou Changchuan Technology Co.,Ltd (SZSE:300604) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Hangzhou Changchuan TechnologyLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Hangzhou Changchuan TechnologyLtd had CN¥1.08b of debt, an increase on CN¥910.3m, over one year. However, because it has a cash reserve of CN¥1.04b, its net debt is less, at about CN¥44.3m.

How Healthy Is Hangzhou Changchuan TechnologyLtd's Balance Sheet?

According to the last reported balance sheet, Hangzhou Changchuan TechnologyLtd had liabilities of CN¥2.54b due within 12 months, and liabilities of CN¥443.7m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.04b as well as receivables valued at CN¥1.50b due within 12 months. So it has liabilities totalling CN¥450.7m more than its cash and near-term receivables, combined.

This state of affairs indicates that Hangzhou Changchuan 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¥32.9b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Hangzhou Changchuan TechnologyLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With debt at a measly 0.085 times EBITDA and EBIT covering interest a whopping 48.6 times, it's clear that Hangzhou Changchuan TechnologyLtd is not a desperate borrower. So relative to past earnings, the debt load seems trivial. Better yet, Hangzhou Changchuan TechnologyLtd grew its EBIT by 1,667% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hangzhou Changchuan TechnologyLtd can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hangzhou Changchuan TechnologyLtd 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

The good news is that Hangzhou Changchuan TechnologyLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. When we consider the range of factors above, it looks like Hangzhou Changchuan TechnologyLtd is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. To that end, you should be aware of the 2 warning signs we've spotted with Hangzhou Changchuan TechnologyLtd .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.