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 Bozhon Precision Industry Technology Co.,Ltd. (SHSE:688097) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Bozhon Precision Industry TechnologyLtd's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Bozhon Precision Industry TechnologyLtd had debt of CN¥1.85b, up from CN¥1.43b in one year. However, because it has a cash reserve of CN¥1.07b, its net debt is less, at about CN¥782.4m.

How Healthy Is Bozhon Precision Industry TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Bozhon Precision Industry TechnologyLtd had liabilities of CN¥4.24b due within 12 months and liabilities of CN¥406.1m due beyond that. On the other hand, it had cash of CN¥1.07b and CN¥3.04b worth of receivables due within a year. So it has liabilities totalling CN¥546.9m more than its cash and near-term receivables, combined.

Of course, Bozhon Precision Industry TechnologyLtd has a market capitalization of CN¥10.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

With a debt to EBITDA ratio of 1.8, Bozhon Precision Industry TechnologyLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.0 times interest expense) certainly does not do anything to dispel this impression. Shareholders should be aware that Bozhon Precision Industry TechnologyLtd's EBIT was down 25% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Bozhon Precision Industry TechnologyLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, Bozhon Precision Industry TechnologyLtd 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 Bozhon Precision Industry TechnologyLtd'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 Bozhon Precision Industry TechnologyLtd's debt is making it 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 2 warning signs with Bozhon Precision Industry TechnologyLtd , and understanding them should be part of your investment process.

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.