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. Importantly, Star Lake Bioscience Co., Inc.Zhaoqing Guangdong (SHSE:600866) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Star Lake BioscienceZhaoqing Guangdong Carry?

The image below, which you can click on for greater detail, shows that Star Lake BioscienceZhaoqing Guangdong had debt of CN¥4.29b at the end of March 2024, a reduction from CN¥5.57b over a year. However, because it has a cash reserve of CN¥1.05b, its net debt is less, at about CN¥3.23b.

How Strong Is Star Lake BioscienceZhaoqing Guangdong's Balance Sheet?

According to the last reported balance sheet, Star Lake BioscienceZhaoqing Guangdong had liabilities of CN¥4.82b due within 12 months, and liabilities of CN¥1.93b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.05b as well as receivables valued at CN¥1.40b due within 12 months. So it has liabilities totalling CN¥4.30b more than its cash and near-term receivables, combined.

Star Lake BioscienceZhaoqing Guangdong has a market capitalization of CN¥10.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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).

With a debt to EBITDA ratio of 1.5, Star Lake BioscienceZhaoqing Guangdong uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.5 times its interest expenses harmonizes with that theme. On the other hand, Star Lake BioscienceZhaoqing Guangdong's EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Star Lake BioscienceZhaoqing Guangdong 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Star Lake BioscienceZhaoqing Guangdong recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Star Lake BioscienceZhaoqing Guangdong's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Star Lake BioscienceZhaoqing Guangdong's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Star Lake BioscienceZhaoqing Guangdong , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.