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 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 note that Digital China Group Co., Ltd. (SZSE:000034) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Digital China Group Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Digital China Group had debt of CN¥15.5b, up from CN¥12.8b in one year. However, it does have CN¥4.70b in cash offsetting this, leading to net debt of about CN¥10.8b.

A Look At Digital China Group's Liabilities

We can see from the most recent balance sheet that Digital China Group had liabilities of CN¥30.3b falling due within a year, and liabilities of CN¥4.65b due beyond that. On the other hand, it had cash of CN¥4.70b and CN¥13.3b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥16.9b.

This deficit is considerable relative to its market capitalization of CN¥23.7b, so it does suggest shareholders should keep an eye on Digital China Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

Digital China Group's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Digital China Group grew its EBIT a smooth 65% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Digital China 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.

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. Looking at the most recent three years, Digital China Group recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Digital China Group's net debt to EBITDA and interest cover 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 Digital China Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Digital China Group is showing 1 warning sign in our investment analysis , you should know about...

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.