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 can see that Wedge Industrial Co.,Ltd. (SZSE:000534) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Wedge IndustrialLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Wedge IndustrialLtd had CN¥1.18b of debt, an increase on CN¥631.8m, over one year. On the flip side, it has CN¥225.6m in cash leading to net debt of about CN¥950.6m.

A Look At Wedge IndustrialLtd's Liabilities

The latest balance sheet data shows that Wedge IndustrialLtd had liabilities of CN¥838.6m due within a year, and liabilities of CN¥1.16b falling due after that. Offsetting these obligations, it had cash of CN¥225.6m as well as receivables valued at CN¥448.6m due within 12 months. So its liabilities total CN¥1.32b more than the combination of its cash and short-term receivables.

Wedge IndustrialLtd has a market capitalization of CN¥5.29b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Wedge IndustrialLtd has net debt to EBITDA of 3.9 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 8.2 suggests it can easily service that debt. One way Wedge IndustrialLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Wedge IndustrialLtd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 that EBIT is backed by free cash flow. During the last three years, Wedge IndustrialLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Wedge IndustrialLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Wedge IndustrialLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that Wedge IndustrialLtd is showing 3 warning signs in our investment analysis , and 2 of those are a bit concerning...

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.