Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Union Semiconductor (Hefei) Co., Ltd. (SHSE:688403) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Union Semiconductor (Hefei)'s Net Debt?

As you can see below, at the end of June 2024, Union Semiconductor (Hefei) had CN¥511.5m of debt, up from none a year ago. Click the image for more detail. However, it also had CN¥245.8m in cash, and so its net debt is CN¥265.7m.

A Look At Union Semiconductor (Hefei)'s Liabilities

Zooming in on the latest balance sheet data, we can see that Union Semiconductor (Hefei) had liabilities of CN¥626.2m due within 12 months and liabilities of CN¥149.7m due beyond that. Offsetting this, it had CN¥245.8m in cash and CN¥241.4m in receivables that were due within 12 months. So its liabilities total CN¥288.6m more than the combination of its cash and short-term receivables.

Since publicly traded Union Semiconductor (Hefei) shares are worth a total of CN¥7.79b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Union Semiconductor (Hefei) has a low debt to EBITDA ratio of only 0.57. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. Also positive, Union Semiconductor (Hefei) grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Union Semiconductor (Hefei) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Union Semiconductor (Hefei) saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, Union Semiconductor (Hefei)'s impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Union Semiconductor (Hefei) can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Union Semiconductor (Hefei) is showing 3 warning signs in our investment analysis , and 1 of those is potentially serious...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.