Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Sunward Intelligent Equipment Co., Ltd. (SZSE:002097) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Sunward Intelligent Equipment's Net Debt?

The chart below, which you can click on for greater detail, shows that Sunward Intelligent Equipment had CN¥10.4b in debt in March 2024; about the same as the year before. However, because it has a cash reserve of CN¥1.78b, its net debt is less, at about CN¥8.58b.

How Strong Is Sunward Intelligent Equipment's Balance Sheet?

According to the last reported balance sheet, Sunward Intelligent Equipment had liabilities of CN¥9.28b due within 12 months, and liabilities of CN¥7.19b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.78b as well as receivables valued at CN¥7.92b due within 12 months. So it has liabilities totalling CN¥6.78b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥6.46b 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Sunward Intelligent Equipment shareholders face the double whammy of a high net debt to EBITDA ratio (15.0), and fairly weak interest coverage, since EBIT is just 0.23 times the interest expense. The debt burden here is substantial. One redeeming factor for Sunward Intelligent Equipment is that it turned last year's EBIT loss into a gain of CN¥75m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Sunward Intelligent Equipment's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Sunward Intelligent Equipment 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

To be frank both Sunward Intelligent Equipment's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Sunward Intelligent Equipment has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example Sunward Intelligent Equipment has 5 warning signs (and 4 which can't be ignored) we think 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com