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.' 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. Importantly, Xiamen Changelight Co., Ltd. (SZSE:300102) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Xiamen Changelight Carry?

As you can see below, at the end of March 2024, Xiamen Changelight had CN¥1.48b of debt, up from CN¥1.33b a year ago. Click the image for more detail. On the flip side, it has CN¥1.31b in cash leading to net debt of about CN¥165.4m.

How Healthy Is Xiamen Changelight's Balance Sheet?

According to the last reported balance sheet, Xiamen Changelight had liabilities of CN¥1.58b due within 12 months, and liabilities of CN¥962.7m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.31b as well as receivables valued at CN¥1.19b due within 12 months. So these liquid assets roughly match the total liabilities.

This state of affairs indicates that Xiamen Changelight's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥5.14b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Xiamen Changelight has a very low debt to EBITDA ratio of 0.38 so it is strange to see weak interest coverage, with last year's EBIT being only 1.6 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Notably, Xiamen Changelight made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥52m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Xiamen Changelight's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Xiamen Changelight burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Xiamen Changelight's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. We think that Xiamen Changelight's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 1 warning sign for Xiamen Changelight that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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