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.' 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 can see that DongGuan YuTong Optical Technology Co.,Ltd. (SZSE:300790) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

How Much Debt Does DongGuan YuTong Optical TechnologyLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2024 DongGuan YuTong Optical TechnologyLtd had debt of CN¥2.42b, up from CN¥1.90b in one year. However, it does have CN¥651.9m in cash offsetting this, leading to net debt of about CN¥1.77b.

How Strong Is DongGuan YuTong Optical TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that DongGuan YuTong Optical TechnologyLtd had liabilities of CN¥2.16b due within 12 months and liabilities of CN¥1.04b due beyond that. On the other hand, it had cash of CN¥651.9m and CN¥924.0m worth of receivables due within a year. So its liabilities total CN¥1.62b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since DongGuan YuTong Optical TechnologyLtd has a market capitalization of CN¥6.28b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

DongGuan YuTong Optical TechnologyLtd has a debt to EBITDA ratio of 4.0 and its EBIT covered its interest expense 3.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, it should be some comfort for shareholders to recall that DongGuan YuTong Optical TechnologyLtd actually grew its EBIT by a hefty 139%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if DongGuan YuTong Optical 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, DongGuan YuTong Optical TechnologyLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

DongGuan YuTong Optical TechnologyLtd's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. We think that DongGuan YuTong Optical 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. 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. For example, we've discovered 3 warning signs for DongGuan YuTong Optical TechnologyLtd (1 is potentially serious!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.