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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Guangdong HEC Technology Holding Co., Ltd (SHSE:600673) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Guangdong HEC Technology Holding's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Guangdong HEC Technology Holding had CN¥11.9b of debt, an increase on CN¥9.68b, over one year. However, it does have CN¥4.95b in cash offsetting this, leading to net debt of about CN¥6.92b.

How Healthy Is Guangdong HEC Technology Holding's Balance Sheet?

The latest balance sheet data shows that Guangdong HEC Technology Holding had liabilities of CN¥12.2b due within a year, and liabilities of CN¥3.86b falling due after that. On the other hand, it had cash of CN¥4.95b and CN¥3.30b worth of receivables due within a year. So it has liabilities totalling CN¥7.76b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Guangdong HEC Technology Holding is worth CN¥18.9b, 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.

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

Guangdong HEC Technology Holding has a rather high debt to EBITDA ratio of 7.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. Worse, Guangdong HEC Technology Holding's EBIT was down 25% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Guangdong HEC Technology Holding'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 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. During the last three years, Guangdong HEC Technology Holding 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

On the face of it, Guangdong HEC Technology Holding's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. After considering the datapoints discussed, we think Guangdong HEC Technology Holding has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Be aware that Guangdong HEC Technology Holding is showing 5 warning signs in our investment analysis , and 2 of those don't sit too well with us...

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.