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 SHENZHEN TOPRAYSOLAR Co.,Ltd. (SZSE:002218) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is SHENZHEN TOPRAYSOLARLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 SHENZHEN TOPRAYSOLARLtd had debt of CN¥1.90b, up from CN¥1.64b in one year. However, because it has a cash reserve of CN¥769.9m, its net debt is less, at about CN¥1.13b.

How Healthy Is SHENZHEN TOPRAYSOLARLtd's Balance Sheet?

According to the last reported balance sheet, SHENZHEN TOPRAYSOLARLtd had liabilities of CN¥875.2m due within 12 months, and liabilities of CN¥1.79b due beyond 12 months. On the other hand, it had cash of CN¥769.9m and CN¥1.53b worth of receivables due within a year. So it has liabilities totalling CN¥370.0m more than its cash and near-term receivables, combined.

Since publicly traded SHENZHEN TOPRAYSOLARLtd shares are worth a total of CN¥5.17b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While SHENZHEN TOPRAYSOLARLtd's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, SHENZHEN TOPRAYSOLARLtd saw its EBIT tank 27% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 SHENZHEN TOPRAYSOLARLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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, SHENZHEN TOPRAYSOLARLtd reported free cash flow worth 13% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, SHENZHEN TOPRAYSOLARLtd's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Overall, we think it's fair to say that SHENZHEN TOPRAYSOLARLtd has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. We've identified 3 warning signs with SHENZHEN TOPRAYSOLARLtd (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.