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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Hangzhou Silan Microelectronics Co.,Ltd (SHSE:600460) does carry debt. 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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Hangzhou Silan MicroelectronicsLtd Carry?

The chart below, which you can click on for greater detail, shows that Hangzhou Silan MicroelectronicsLtd had CN¥5.97b in debt in September 2024; about the same as the year before. On the flip side, it has CN¥4.70b in cash leading to net debt of about CN¥1.27b.

How Strong Is Hangzhou Silan MicroelectronicsLtd's Balance Sheet?

The latest balance sheet data shows that Hangzhou Silan MicroelectronicsLtd had liabilities of CN¥6.95b due within a year, and liabilities of CN¥3.76b falling due after that. Offsetting these obligations, it had cash of CN¥4.70b as well as receivables valued at CN¥4.36b due within 12 months. So it has liabilities totalling CN¥1.65b more than its cash and near-term receivables, combined.

Of course, Hangzhou Silan MicroelectronicsLtd has a market capitalization of CN¥46.5b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hangzhou Silan MicroelectronicsLtd's net debt is only 0.95 times its EBITDA. And its EBIT easily covers its interest expense, being 15.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Hangzhou Silan MicroelectronicsLtd's saving grace is its low debt levels, because its EBIT has tanked 49% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hangzhou Silan MicroelectronicsLtd 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hangzhou Silan MicroelectronicsLtd 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

Hangzhou Silan MicroelectronicsLtd's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Hangzhou Silan MicroelectronicsLtd is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Hangzhou Silan MicroelectronicsLtd is showing 2 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.