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.' 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. We can see that Sunstone Development Co., Ltd. (SHSE:603612) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sunstone Development's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Sunstone Development had CN¥8.30b of debt, an increase on CN¥7.52b, over one year. However, it also had CN¥2.74b in cash, and so its net debt is CN¥5.56b.

How Healthy Is Sunstone Development's Balance Sheet?

According to the last reported balance sheet, Sunstone Development had liabilities of CN¥6.94b due within 12 months, and liabilities of CN¥3.85b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.74b as well as receivables valued at CN¥3.30b due within 12 months. So it has liabilities totalling CN¥4.75b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥7.20b, so it does suggest shareholders should keep an eye on Sunstone Development's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Sunstone Development like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The silver lining is that Sunstone Development grew its EBIT by 909% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sunstone 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 company can only pay off debt with cold hard cash, not accounting profits. 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, Sunstone Development burned a lot of cash. 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

On the face of it, Sunstone Development's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sunstone Development stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Sunstone Development , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.