David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Shenzhen Huaqiang Industry Co., Ltd. (SZSE:000062) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

How Much Debt Does Shenzhen Huaqiang Industry Carry?

The chart below, which you can click on for greater detail, shows that Shenzhen Huaqiang Industry had CN¥6.23b in debt in June 2024; about the same as the year before. However, it also had CN¥2.61b in cash, and so its net debt is CN¥3.62b.

A Look At Shenzhen Huaqiang Industry's Liabilities

According to the last reported balance sheet, Shenzhen Huaqiang Industry had liabilities of CN¥7.06b due within 12 months, and liabilities of CN¥1.28b due beyond 12 months. On the other hand, it had cash of CN¥2.61b and CN¥5.50b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥235.2m.

Having regard to Shenzhen Huaqiang Industry's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥32.3b company is short on cash, but still worth keeping an eye on the balance sheet.

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).

Shenzhen Huaqiang Industry has net debt to EBITDA of 3.6 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.2 suggests it can easily service that debt. Unfortunately, Shenzhen Huaqiang Industry's EBIT flopped 14% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shenzhen Huaqiang Industry will need earnings to service that debt. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shenzhen Huaqiang Industry produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Shenzhen Huaqiang Industry's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Shenzhen Huaqiang Industry'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. 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. To that end, you should learn about the 5 warning signs we've spotted with Shenzhen Huaqiang Industry (including 3 which can't be ignored) .

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.