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 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. We can see that Shenzhen Kingdom Sci-Tech Co., Ltd (SHSE:600446) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Shenzhen Kingdom Sci-Tech Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shenzhen Kingdom Sci-Tech had CN¥1.37b of debt, an increase on CN¥1.31b, over one year. But it also has CN¥2.20b in cash to offset that, meaning it has CN¥830.1m net cash.

A Look At Shenzhen Kingdom Sci-Tech's Liabilities

We can see from the most recent balance sheet that Shenzhen Kingdom Sci-Tech had liabilities of CN¥2.63b falling due within a year, and liabilities of CN¥42.1m due beyond that. On the other hand, it had cash of CN¥2.20b and CN¥1.53b worth of receivables due within a year. So it actually has CN¥1.05b more liquid assets than total liabilities.

This short term liquidity is a sign that Shenzhen Kingdom Sci-Tech could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Shenzhen Kingdom Sci-Tech has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Shenzhen Kingdom Sci-Tech if management cannot prevent a repeat of the 46% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shenzhen Kingdom Sci-Tech can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Shenzhen Kingdom Sci-Tech may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Shenzhen Kingdom Sci-Tech produced sturdy free cash flow equating to 80% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shenzhen Kingdom Sci-Tech has CN¥830.1m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥508m, being 80% of its EBIT. So we don't have any problem with Shenzhen Kingdom Sci-Tech's use of debt. 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. Be aware that Shenzhen Kingdom Sci-Tech 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.