Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Shanghai Bright Power Semiconductor Co., Ltd. (SHSE:688368) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Shanghai Bright Power Semiconductor's Debt?

The image below, which you can click on for greater detail, shows that Shanghai Bright Power Semiconductor had debt of CN¥341.7m at the end of June 2024, a reduction from CN¥589.2m over a year. However, it does have CN¥320.5m in cash offsetting this, leading to net debt of about CN¥21.2m.

How Strong Is Shanghai Bright Power Semiconductor's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Bright Power Semiconductor had liabilities of CN¥600.8m due within 12 months and liabilities of CN¥163.4m due beyond that. On the other hand, it had cash of CN¥320.5m and CN¥376.1m worth of receivables due within a year. So its liabilities total CN¥67.7m more than the combination of its cash and short-term receivables.

Having regard to Shanghai Bright Power Semiconductor's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥4.74b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Shanghai Bright Power Semiconductor has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.28 and interest cover of 2.8 times, it seems to us that Shanghai Bright Power Semiconductor is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Shanghai Bright Power Semiconductor improved its EBIT from a last year's loss to a positive CN¥31m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Bright Power Semiconductor 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shanghai Bright Power Semiconductor actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Shanghai Bright Power Semiconductor's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. Taking all this data into account, it seems to us that Shanghai Bright Power Semiconductor takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. While Shanghai Bright Power Semiconductor didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

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.