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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Shenzhen Das Intellitech Co., Ltd. (SZSE:002421) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Das Intellitech's Debt?

The chart below, which you can click on for greater detail, shows that Shenzhen Das Intellitech had CN¥3.23b in debt in March 2024; about the same as the year before. However, it does have CN¥1.60b in cash offsetting this, leading to net debt of about CN¥1.63b.

How Healthy Is Shenzhen Das Intellitech's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Das Intellitech had liabilities of CN¥3.24b due within 12 months and liabilities of CN¥2.79b due beyond that. Offsetting these obligations, it had cash of CN¥1.60b as well as receivables valued at CN¥3.24b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.19b.

This deficit isn't so bad because Shenzhen Das Intellitech is worth CN¥4.79b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shenzhen Das Intellitech has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. However, its interest coverage of 4.9 is reasonably strong, which is a good sign. Importantly Shenzhen Das Intellitech's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. 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 Das Intellitech 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Shenzhen Das Intellitech reported free cash flow worth 3.3% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While Shenzhen Das Intellitech's conversion of EBIT to free cash flow makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its level of total liabilities gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Shenzhen Das Intellitech is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Case in point: We've spotted 3 warning signs for Shenzhen Das Intellitech you should be aware of, and 1 of them makes us a bit uncomfortable.

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.

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