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.' 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, Shanghai V-Test Semiconductor Tech. Co., Ltd. (SHSE:688372) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Shanghai V-Test Semiconductor Tech Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Shanghai V-Test Semiconductor Tech had debt of CN¥1.36b, up from CN¥723.1m in one year. However, because it has a cash reserve of CN¥220.4m, its net debt is less, at about CN¥1.13b.

How Healthy Is Shanghai V-Test Semiconductor Tech's Balance Sheet?

According to the last reported balance sheet, Shanghai V-Test Semiconductor Tech had liabilities of CN¥582.0m due within 12 months, and liabilities of CN¥1.26b due beyond 12 months. Offsetting these obligations, it had cash of CN¥220.4m as well as receivables valued at CN¥403.6m due within 12 months. So it has liabilities totalling CN¥1.22b more than its cash and near-term receivables, combined.

Given Shanghai V-Test Semiconductor Tech has a market capitalization of CN¥7.91b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Shanghai V-Test Semiconductor Tech has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Shanghai V-Test Semiconductor Tech saw its EBIT tank 20% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Shanghai V-Test Semiconductor Tech 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shanghai V-Test Semiconductor Tech 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

On the face of it, Shanghai V-Test Semiconductor Tech's conversion of EBIT to free cash flow 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 at least its level of total liabilities is not so bad. Looking at the bigger picture, it seems clear to us that Shanghai V-Test Semiconductor Tech's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Shanghai V-Test Semiconductor Tech (2 don't sit too well with us) you should be aware of.

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.

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.