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, SKSHU Paint Co.,Ltd. (SHSE:603737) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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 SKSHU PaintLtd's Debt?

As you can see below, SKSHU PaintLtd had CN¥4.01b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥2.11b in cash leading to net debt of about CN¥1.90b.

How Strong Is SKSHU PaintLtd's Balance Sheet?

According to the last reported balance sheet, SKSHU PaintLtd had liabilities of CN¥10.6b due within 12 months, and liabilities of CN¥1.72b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.11b as well as receivables valued at CN¥5.01b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.17b.

While this might seem like a lot, it is not so bad since SKSHU PaintLtd has a market capitalization of CN¥24.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While SKSHU PaintLtd's debt to EBITDA ratio (4.0) suggests that it uses some debt, its interest cover is very weak, at 0.067, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, SKSHU PaintLtd saw its EBIT tank 98% 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if SKSHU PaintLtd 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, SKSHU PaintLtd actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither SKSHU PaintLtd's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think SKSHU PaintLtd'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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for SKSHU PaintLtd you should be aware of, and 1 of them is a bit unpleasant.

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.