Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 ChengDu Hi-Tech Development Co., Ltd. (SZSE:000628) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does ChengDu Hi-Tech Development Carry?

The image below, which you can click on for greater detail, shows that at March 2024 ChengDu Hi-Tech Development had debt of CN¥2.62b, up from CN¥2.17b in one year. However, it also had CN¥512.5m in cash, and so its net debt is CN¥2.11b.

How Strong Is ChengDu Hi-Tech Development's Balance Sheet?

We can see from the most recent balance sheet that ChengDu Hi-Tech Development had liabilities of CN¥8.19b falling due within a year, and liabilities of CN¥2.04b due beyond that. Offsetting these obligations, it had cash of CN¥512.5m as well as receivables valued at CN¥9.28b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥432.2m.

Given ChengDu Hi-Tech Development has a market capitalization of CN¥14.8b, 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.

Strangely ChengDu Hi-Tech Development has a sky high EBITDA ratio of 5.1, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that ChengDu Hi-Tech Development's EBIT shot up like bamboo after rain, gaining 57% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is ChengDu Hi-Tech Development's earnings that will influence how the balance sheet holds up in the future. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, ChengDu Hi-Tech Development saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We weren't impressed with ChengDu Hi-Tech Development's net debt to EBITDA, and its conversion of EBIT to free cash flow made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble covering its interest expense with its EBIT. Considering this range of data points, we think ChengDu Hi-Tech Development 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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with ChengDu Hi-Tech Development .

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