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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Baosheng Science and Technology Innovation Co.,Ltd. (SHSE:600973) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Baosheng Science and Technology InnovationLtd Carry?

As you can see below, Baosheng Science and Technology InnovationLtd had CN¥12.4b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥3.83b in cash, and so its net debt is CN¥8.56b.

How Strong Is Baosheng Science and Technology InnovationLtd's Balance Sheet?

The latest balance sheet data shows that Baosheng Science and Technology InnovationLtd had liabilities of CN¥14.0b due within a year, and liabilities of CN¥3.37b falling due after that. Offsetting this, it had CN¥3.83b in cash and CN¥6.96b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.63b.

When you consider that this deficiency exceeds the company's CN¥5.60b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 8.0 hit our confidence in Baosheng Science and Technology InnovationLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Baosheng Science and Technology InnovationLtd grew its EBIT at 15% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Baosheng Science and Technology InnovationLtd can strengthen its balance sheet over time. 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, Baosheng Science and Technology InnovationLtd recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Baosheng Science and Technology InnovationLtd's interest cover and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Baosheng Science and Technology InnovationLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 4 warning signs for Baosheng Science and Technology InnovationLtd (1 is a bit concerning!) that you should be aware of before investing here.

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.