Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that ShenZhen YUTO Packaging Technology Co., Ltd. (SZSE:002831) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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.

What Is ShenZhen YUTO Packaging Technology's Debt?

The chart below, which you can click on for greater detail, shows that ShenZhen YUTO Packaging Technology had CN¥5.49b in debt in September 2023; about the same as the year before. However, it also had CN¥4.00b in cash, and so its net debt is CN¥1.49b.

A Look At ShenZhen YUTO Packaging Technology's Liabilities

The latest balance sheet data shows that ShenZhen YUTO Packaging Technology had liabilities of CN¥8.76b due within a year, and liabilities of CN¥1.45b falling due after that. On the other hand, it had cash of CN¥4.00b and CN¥5.72b worth of receivables due within a year. So it has liabilities totalling CN¥491.4m more than its cash and near-term receivables, combined.

This state of affairs indicates that ShenZhen YUTO Packaging Technology'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¥25.0b company is short on cash, but still worth keeping an eye on the balance sheet.

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.

ShenZhen YUTO Packaging Technology's net debt is only 0.64 times its EBITDA. And its EBIT easily covers its interest expense, being 19.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, ShenZhen YUTO Packaging Technology grew its EBIT by 2.8% in the last year, making that debt load look even more manageable. 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 ShenZhen YUTO Packaging Technology 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, ShenZhen YUTO Packaging Technology's free cash flow amounted to 37% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that ShenZhen YUTO Packaging Technology's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that ShenZhen YUTO Packaging Technology can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Be aware that ShenZhen YUTO Packaging Technology is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.