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. Importantly, Shanghai Fudan Microelectronics Group Company Limited (HKG:1385) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Shanghai Fudan Microelectronics Group Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Shanghai Fudan Microelectronics Group had debt of CN¥1.69b, up from CN¥1.40b in one year. However, it does have CN¥1.01b in cash offsetting this, leading to net debt of about CN¥671.2m.

How Healthy Is Shanghai Fudan Microelectronics Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Fudan Microelectronics Group had liabilities of CN¥2.21b due within 12 months and liabilities of CN¥289.4m due beyond that. Offsetting these obligations, it had cash of CN¥1.01b as well as receivables valued at CN¥1.85b due within 12 months. So it can boast CN¥366.1m more liquid assets than total liabilities.

Having regard to Shanghai Fudan Microelectronics Group's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥26.6b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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

Shanghai Fudan Microelectronics Group has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 15.3 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Shanghai Fudan Microelectronics Group's saving grace is its low debt levels, because its EBIT has tanked 58% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Shanghai Fudan Microelectronics Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shanghai Fudan Microelectronics Group 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

Shanghai Fudan Microelectronics Group's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Shanghai Fudan Microelectronics Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Fudan Microelectronics Group you should know about.

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.