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.' 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. Importantly, Skyworth Digital Co., Ltd. (SZSE:000810) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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 Skyworth Digital's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Skyworth Digital had CN¥939.9m of debt, an increase on CN¥344.9m, over one year. But on the other hand it also has CN¥3.64b in cash, leading to a CN¥2.70b net cash position.

How Healthy Is Skyworth Digital's Balance Sheet?

The latest balance sheet data shows that Skyworth Digital had liabilities of CN¥4.16b due within a year, and liabilities of CN¥234.1m falling due after that. Offsetting this, it had CN¥3.64b in cash and CN¥3.10b in receivables that were due within 12 months. So it actually has CN¥2.36b more liquid assets than total liabilities.

This excess liquidity suggests that Skyworth Digital is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Skyworth Digital has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Skyworth Digital's saving grace is its low debt levels, because its EBIT has tanked 32% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Skyworth Digital's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Skyworth Digital 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. Happily for any shareholders, Skyworth Digital actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While it is always sensible to investigate a company's debt, in this case Skyworth Digital has CN¥2.70b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 129% of that EBIT to free cash flow, bringing in CN¥8.7m. So is Skyworth Digital's debt a risk? It doesn't seem so to us. 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. Be aware that Skyworth Digital is showing 2 warning signs in our investment analysis , and 1 of those 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.

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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.