The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Espressif Systems (Shanghai) Co., Ltd. (SHSE:688018) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Espressif Systems (Shanghai)'s Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Espressif Systems (Shanghai) had debt of CN¥19.9m, up from none in one year. However, its balance sheet shows it holds CN¥507.2m in cash, so it actually has CN¥487.3m net cash.

How Healthy Is Espressif Systems (Shanghai)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Espressif Systems (Shanghai) had liabilities of CN¥202.8m due within 12 months and liabilities of CN¥70.1m due beyond that. On the other hand, it had cash of CN¥507.2m and CN¥287.6m worth of receivables due within a year. So it can boast CN¥521.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Espressif Systems (Shanghai) could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Espressif Systems (Shanghai) has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Espressif Systems (Shanghai) grew its EBIT by 107% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Espressif Systems (Shanghai)'s ability to maintain a healthy balance sheet going forward. 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. Espressif Systems (Shanghai) may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Espressif Systems (Shanghai) generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case Espressif Systems (Shanghai) has CN¥487.3m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in CN¥243m. So is Espressif Systems (Shanghai)'s debt a risk? It doesn't seem so to us. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Espressif Systems (Shanghai)'s earnings per share history for free.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.