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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Yunnan Nantian Electronics Information Co.,Ltd. (SZSE:000948) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Yunnan Nantian Electronics InformationLtd's Net Debt?

As you can see below, at the end of September 2024, Yunnan Nantian Electronics InformationLtd had CN¥1.64b of debt, up from CN¥1.44b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.36b, its net debt is less, at about CN¥285.6m.

A Look At Yunnan Nantian Electronics InformationLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Yunnan Nantian Electronics InformationLtd had liabilities of CN¥5.47b due within 12 months and liabilities of CN¥476.3m due beyond that. On the other hand, it had cash of CN¥1.36b and CN¥2.50b worth of receivables due within a year. So it has liabilities totalling CN¥2.09b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Yunnan Nantian Electronics InformationLtd has a market capitalization of CN¥7.39b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Yunnan Nantian Electronics InformationLtd's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 15.9 times, makes us even more comfortable. In fact Yunnan Nantian Electronics InformationLtd's saving grace is its low debt levels, because its EBIT has tanked 47% 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 you can't view debt in total isolation; since Yunnan Nantian Electronics InformationLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Yunnan Nantian Electronics InformationLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Yunnan Nantian Electronics InformationLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Yunnan Nantian Electronics InformationLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should be aware of the 3 warning signs we've spotted with Yunnan Nantian Electronics InformationLtd .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.