David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 note that Fujian Sunner Development Co., Ltd. (SZSE:002299) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Fujian Sunner Development Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Fujian Sunner Development had debt of CN¥7.68b, up from CN¥6.97b in one year. However, it also had CN¥2.29b in cash, and so its net debt is CN¥5.40b.

How Strong Is Fujian Sunner Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fujian Sunner Development had liabilities of CN¥11.2b due within 12 months and liabilities of CN¥942.4m due beyond that. Offsetting these obligations, it had cash of CN¥2.29b as well as receivables valued at CN¥920.7m due within 12 months. So its liabilities total CN¥8.97b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Fujian Sunner Development is worth CN¥15.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Fujian Sunner Development has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 4.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Shareholders should be aware that Fujian Sunner Development's EBIT was down 58% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Fujian Sunner Development 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Fujian Sunner Development produced sturdy free cash flow equating to 67% 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.

Our View

Fujian Sunner Development's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. Taking the abovementioned factors together we do think Fujian Sunner Development's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Fujian Sunner Development is showing 3 warning signs 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.