The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Focused Photonics (Hangzhou), Inc. (SZSE:300203) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Focused Photonics (Hangzhou) Carry?

You can click the graphic below for the historical numbers, but it shows that Focused Photonics (Hangzhou) had CN¥3.44b of debt in June 2024, down from CN¥3.83b, one year before. However, it does have CN¥864.0m in cash offsetting this, leading to net debt of about CN¥2.57b.

How Strong Is Focused Photonics (Hangzhou)'s Balance Sheet?

According to the last reported balance sheet, Focused Photonics (Hangzhou) had liabilities of CN¥3.52b due within 12 months, and liabilities of CN¥2.60b due beyond 12 months. On the other hand, it had cash of CN¥864.0m and CN¥1.27b worth of receivables due within a year. So its liabilities total CN¥3.98b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥6.64b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. 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 Focused Photonics (Hangzhou) 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.

Over 12 months, Focused Photonics (Hangzhou) reported revenue of CN¥3.4b, which is a gain of 2.7%, although it did not report any earnings before interest and tax. That rate of growth is a bit slow for our taste, but it takes all types to make a world.

Caveat Emptor

Importantly, Focused Photonics (Hangzhou) had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at CN¥154m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of CN¥140m into a profit. In the meantime, we consider the stock very risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Focused Photonics (Hangzhou) that you should be aware of.

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.