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.' 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. Importantly, Sunward Intelligent Equipment Co., Ltd. (SZSE:002097) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Sunward Intelligent Equipment's Net Debt?

The chart below, which you can click on for greater detail, shows that Sunward Intelligent Equipment had CN¥10.2b in debt in September 2024; about the same as the year before. On the flip side, it has CN¥1.76b in cash leading to net debt of about CN¥8.43b.

A Look At Sunward Intelligent Equipment's Liabilities

Zooming in on the latest balance sheet data, we can see that Sunward Intelligent Equipment had liabilities of CN¥9.61b due within 12 months and liabilities of CN¥6.99b due beyond that. Offsetting these obligations, it had cash of CN¥1.76b as well as receivables valued at CN¥8.08b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.76b.

This is a mountain of leverage relative to its market capitalization of CN¥8.46b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Sunward Intelligent Equipment shareholders face the double whammy of a high net debt to EBITDA ratio (13.7), and fairly weak interest coverage, since EBIT is just 0.46 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Sunward Intelligent Equipment is that it turned last year's EBIT loss into a gain of CN¥149m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sunward Intelligent Equipment 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Sunward Intelligent Equipment actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither Sunward Intelligent Equipment's ability to cover its interest expense with its EBIT 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 convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Sunward Intelligent Equipment's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 4 warning signs we've spotted with Sunward Intelligent Equipment (including 2 which are concerning) .

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.