Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Hengtong Optic-Electric Co., Ltd. (SHSE:600487) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Hengtong Optic-Electric's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Hengtong Optic-Electric had debt of CN¥17.3b, up from CN¥14.7b in one year. However, it also had CN¥9.24b in cash, and so its net debt is CN¥8.06b.

How Strong Is Hengtong Optic-Electric's Balance Sheet?

According to the last reported balance sheet, Hengtong Optic-Electric had liabilities of CN¥27.2b due within 12 months, and liabilities of CN¥6.12b due beyond 12 months. Offsetting these obligations, it had cash of CN¥9.24b as well as receivables valued at CN¥23.1b due within 12 months. So it has liabilities totalling CN¥982.0m more than its cash and near-term receivables, combined.

Of course, Hengtong Optic-Electric has a market capitalization of CN¥31.6b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Hengtong Optic-Electric's net debt to EBITDA ratio of about 2.5 suggests only moderate use of debt. And its commanding EBIT of 11.8 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Hengtong Optic-Electric's EBIT flopped 12% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hengtong Optic-Electric'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hengtong Optic-Electric burned a lot of cash. 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

Hengtong Optic-Electric's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think Hengtong Optic-Electric's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Hengtong Optic-Electric is showing 1 warning sign in our investment analysis , 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.