Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Deren Electronic Co., Ltd. (SZSE:002055) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Deren Electronic's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shenzhen Deren Electronic had CN¥735.5m of debt in March 2024, down from CN¥811.6m, one year before. However, because it has a cash reserve of CN¥305.9m, its net debt is less, at about CN¥429.6m.

How Healthy Is Shenzhen Deren Electronic's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Deren Electronic had liabilities of CN¥3.39b falling due within a year, and liabilities of CN¥1.83b due beyond that. Offsetting these obligations, it had cash of CN¥305.9m as well as receivables valued at CN¥2.42b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.49b.

This deficit is considerable relative to its market capitalization of CN¥4.13b, so it does suggest shareholders should keep an eye on Shenzhen Deren Electronic's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. 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 Deren Electronic 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.

Over 12 months, Shenzhen Deren Electronic made a loss at the EBIT level, and saw its revenue drop to CN¥5.5b, which is a fall of 29%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Shenzhen Deren Electronic's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at CN¥46m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn't help that it burned through CN¥741m of cash over the last year. So in short it's a really risky stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Shenzhen Deren Electronic , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com