Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Shenzhen Huaqiang Industry Co., Ltd. (SZSE:000062) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Huaqiang Industry's Debt?

As you can see below, at the end of March 2024, Shenzhen Huaqiang Industry had CN¥6.51b of debt, up from CN¥5.85b a year ago. Click the image for more detail. However, it also had CN¥2.70b in cash, and so its net debt is CN¥3.82b.

How Strong Is Shenzhen Huaqiang Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Huaqiang Industry had liabilities of CN¥7.19b due within 12 months and liabilities of CN¥1.26b due beyond that. On the other hand, it had cash of CN¥2.70b and CN¥5.26b worth of receivables due within a year. So it has liabilities totalling CN¥498.8m more than its cash and near-term receivables, combined.

Given Shenzhen Huaqiang Industry has a market capitalization of CN¥10.2b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Shenzhen Huaqiang Industry's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 4.0 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, Shenzhen Huaqiang Industry saw its EBIT tank 25% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shenzhen Huaqiang Industry will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Shenzhen Huaqiang Industry's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Shenzhen Huaqiang Industry's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its level of total liabilities is relatively strong. Taking the abovementioned factors together we do think Shenzhen Huaqiang Industry's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Shenzhen Huaqiang Industry is showing 3 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.