Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Shenzhen Easttop Supply Chain Management Co., Ltd. (SZSE:002889) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Shenzhen Easttop Supply Chain Management Carry?

As you can see below, Shenzhen Easttop Supply Chain Management had CN¥1.41b of debt at September 2024, down from CN¥2.14b a year prior. On the flip side, it has CN¥1.09b in cash leading to net debt of about CN¥320.4m.

A Look At Shenzhen Easttop Supply Chain Management's Liabilities

According to the last reported balance sheet, Shenzhen Easttop Supply Chain Management had liabilities of CN¥1.81b due within 12 months, and liabilities of CN¥16.8m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.09b as well as receivables valued at CN¥1.22b due within 12 months. So it actually has CN¥486.4m more liquid assets than total liabilities.

This surplus suggests that Shenzhen Easttop Supply Chain Management has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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

With a debt to EBITDA ratio of 1.6, Shenzhen Easttop Supply Chain Management uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.1 times interest expense) certainly does not do anything to dispel this impression. On the other hand, Shenzhen Easttop Supply Chain Management saw its EBIT drop by 9.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shenzhen Easttop Supply Chain Management will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shenzhen Easttop Supply Chain Management reported free cash flow worth 3.2% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We weren't impressed with Shenzhen Easttop Supply Chain Management's EBIT growth rate, and its conversion of EBIT to free cash flow made us cautious. Balancing that a bit, it has a demonstrated ability level of total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Shenzhen Easttop Supply Chain Management's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Shenzhen Easttop Supply Chain Management has 2 warning signs we think you should be aware of.

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.