Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Shenzhen Capchem Technology Co., Ltd. (SZSE:300037) makes use of debt. But is this debt a concern to shareholders?

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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Shenzhen Capchem Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shenzhen Capchem Technology had CN¥3.23b of debt, an increase on CN¥2.98b, over one year. However, it does have CN¥2.91b in cash offsetting this, leading to net debt of about CN¥328.0m.

How Healthy Is Shenzhen Capchem Technology's Balance Sheet?

According to the last reported balance sheet, Shenzhen Capchem Technology had liabilities of CN¥4.19b due within 12 months, and liabilities of CN¥2.67b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.91b as well as receivables valued at CN¥3.58b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥378.2m.

Having regard to Shenzhen Capchem Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥23.1b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Shenzhen Capchem Technology has a very light debt load indeed.

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.

Shenzhen Capchem Technology has a low net debt to EBITDA ratio of only 0.23. And its EBIT covers its interest expense a whopping 565 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Shenzhen Capchem Technology's saving grace is its low debt levels, because its EBIT has tanked 26% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Shenzhen Capchem Technology'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Shenzhen Capchem Technology's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Based on what we've seen Shenzhen Capchem Technology is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Shenzhen Capchem Technology's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shenzhen Capchem Technology is showing 1 warning sign in our investment analysis , you should know about...

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.