Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Shenzhen WOTE Advanced Materials Co.,Ltd (SZSE:002886) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Shenzhen WOTE Advanced MaterialsLtd's Net Debt?

As you can see below, at the end of September 2024, Shenzhen WOTE Advanced MaterialsLtd had CN¥1.34b of debt, up from CN¥935.3m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥422.4m, its net debt is less, at about CN¥919.8m.

How Healthy Is Shenzhen WOTE Advanced MaterialsLtd's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen WOTE Advanced MaterialsLtd had liabilities of CN¥1.09b falling due within a year, and liabilities of CN¥711.4m due beyond that. On the other hand, it had cash of CN¥422.4m and CN¥481.5m worth of receivables due within a year. So its liabilities total CN¥896.7m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Shenzhen WOTE Advanced MaterialsLtd is worth CN¥3.93b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 6.5 hit our confidence in Shenzhen WOTE Advanced MaterialsLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The good news is that Shenzhen WOTE Advanced MaterialsLtd grew its EBIT a smooth 71% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shenzhen WOTE Advanced MaterialsLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shenzhen WOTE Advanced MaterialsLtd 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

Neither Shenzhen WOTE Advanced MaterialsLtd's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Shenzhen WOTE Advanced MaterialsLtd is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Shenzhen WOTE Advanced MaterialsLtd (of which 1 makes us a bit uncomfortable!) you should know about.

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.

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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.