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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Changzhou Fusion New Material Co., Ltd. (SHSE:688503) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Changzhou Fusion New Material's Net Debt?

As you can see below, at the end of June 2024, Changzhou Fusion New Material had CN¥3.16b of debt, up from CN¥992.2m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.27b, its net debt is less, at about CN¥892.4m.

How Strong Is Changzhou Fusion New Material's Balance Sheet?

The latest balance sheet data shows that Changzhou Fusion New Material had liabilities of CN¥3.94b due within a year, and liabilities of CN¥22.7m falling due after that. Offsetting these obligations, it had cash of CN¥2.27b as well as receivables valued at CN¥3.96b due within 12 months. So it can boast CN¥2.27b more liquid assets than total liabilities.

This excess liquidity is a great indication that Changzhou Fusion New Material's balance sheet is almost as strong as Fort Knox. With this in mind one could posit that its balance sheet means the company is able to handle some adversity.

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.

Changzhou Fusion New Material has a low debt to EBITDA ratio of only 1.2. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. In addition to that, we're happy to report that Changzhou Fusion New Material has boosted its EBIT by 69%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Changzhou Fusion New Material can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Changzhou Fusion New Material saw substantial negative free cash flow, in total. 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

Changzhou Fusion New Material's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Zooming out, Changzhou Fusion New Material seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Changzhou Fusion New Material you should be aware of, and 1 of them makes us a bit uncomfortable.

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.

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