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.' 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. As with many other companies Shenzhen Yitoa Intelligent Control Co.,Ltd. (SZSE:300131) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Yitoa Intelligent ControlLtd's Debt?

The image below, which you can click on for greater detail, shows that Shenzhen Yitoa Intelligent ControlLtd had debt of CN¥619.1m at the end of March 2024, a reduction from CN¥750.3m over a year. However, it does have CN¥371.8m in cash offsetting this, leading to net debt of about CN¥247.2m.

How Strong Is Shenzhen Yitoa Intelligent ControlLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Yitoa Intelligent ControlLtd had liabilities of CN¥1.45b due within 12 months and liabilities of CN¥217.4m due beyond that. On the other hand, it had cash of CN¥371.8m and CN¥1.00b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥296.6m.

Given Shenzhen Yitoa Intelligent ControlLtd has a market capitalization of CN¥5.37b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Shenzhen Yitoa Intelligent ControlLtd's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.6 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Unfortunately, Shenzhen Yitoa Intelligent ControlLtd saw its EBIT slide 9.2% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shenzhen Yitoa Intelligent ControlLtd 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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Shenzhen Yitoa Intelligent ControlLtd recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

We weren't impressed with Shenzhen Yitoa Intelligent ControlLtd's EBIT growth rate, and its interest cover made us cautious. But its conversion of EBIT to free cash flow was significantly redeeming. Considering this range of data points, we think Shenzhen Yitoa Intelligent ControlLtd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Shenzhen Yitoa Intelligent ControlLtd (1 shouldn't be ignored) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.