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.' 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. As with many other companies Shenyang Fortune Precision Equipment Co., Ltd. (SHSE:688409) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shenyang Fortune Precision Equipment's Debt?

As you can see below, at the end of June 2024, Shenyang Fortune Precision Equipment had CN¥1.60b of debt, up from CN¥892.9m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.59b, its net debt is less, at about CN¥9.09m.

How Healthy Is Shenyang Fortune Precision Equipment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenyang Fortune Precision Equipment had liabilities of CN¥1.20b due within 12 months and liabilities of CN¥1.85b due beyond that. Offsetting these obligations, it had cash of CN¥1.59b as well as receivables valued at CN¥1.28b due within 12 months. So its liabilities total CN¥181.8m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Shenyang Fortune Precision Equipment's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥10.9b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Shenyang Fortune Precision Equipment has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

Shenyang Fortune Precision Equipment has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.025. Humorously, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. But the other side of the story is that Shenyang Fortune Precision Equipment saw its EBIT decline by 5.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shenyang Fortune Precision Equipment 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.

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. Over the last three years, Shenyang Fortune Precision Equipment saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shenyang Fortune Precision Equipment's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Shenyang Fortune Precision Equipment's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Shenyang Fortune Precision Equipment (of which 1 can't be ignored!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.