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 can see that Hainan Jinpan Smart Technology Co., Ltd. (SHSE:688676) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hainan Jinpan Smart Technology's Net Debt?

The image below, which you can click on for greater detail, shows that Hainan Jinpan Smart Technology had debt of CN¥1.41b at the end of June 2024, a reduction from CN¥1.48b over a year. However, because it has a cash reserve of CN¥747.7m, its net debt is less, at about CN¥658.1m.

How Strong Is Hainan Jinpan Smart Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hainan Jinpan Smart Technology had liabilities of CN¥3.91b due within 12 months and liabilities of CN¥677.9m due beyond that. Offsetting this, it had CN¥747.7m in cash and CN¥3.30b in receivables that were due within 12 months. So its liabilities total CN¥545.7m more than the combination of its cash and short-term receivables.

Of course, Hainan Jinpan Smart Technology has a market capitalization of CN¥13.9b, 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.

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.

Hainan Jinpan Smart Technology has a low net debt to EBITDA ratio of only 0.78. And its EBIT easily covers its interest expense, being 28.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Hainan Jinpan Smart Technology grew its EBIT by 82% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hainan Jinpan Smart Technology 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hainan Jinpan Smart Technology 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

The good news is that Hainan Jinpan Smart Technology's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Hainan Jinpan Smart Technology can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Hainan Jinpan Smart Technology has 4 warning signs (and 1 which is potentially serious) we think you should know about.

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.