Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Suzhou Secote Precision Electronic Co.,LTD (SHSE:603283) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Suzhou Secote Precision ElectronicLTD's Net Debt?

As you can see below, at the end of September 2024, Suzhou Secote Precision ElectronicLTD had CN¥1.00b of debt, up from CN¥764.3m a year ago. Click the image for more detail. However, it also had CN¥734.0m in cash, and so its net debt is CN¥270.4m.

A Look At Suzhou Secote Precision ElectronicLTD's Liabilities

The latest balance sheet data shows that Suzhou Secote Precision ElectronicLTD had liabilities of CN¥3.11b due within a year, and liabilities of CN¥100.0m falling due after that. On the other hand, it had cash of CN¥734.0m and CN¥2.18b worth of receivables due within a year. So it has liabilities totalling CN¥299.6m more than its cash and near-term receivables, combined.

Since publicly traded Suzhou Secote Precision ElectronicLTD shares are worth a total of CN¥14.0b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Suzhou Secote Precision ElectronicLTD's net debt is only 0.26 times its EBITDA. And its EBIT covers its interest expense a whopping 239 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Suzhou Secote Precision ElectronicLTD grew its EBIT by 80% over the last twelve months, and that growth will make it easier to handle its debt. 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 Suzhou Secote Precision ElectronicLTD 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Suzhou Secote Precision ElectronicLTD recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Suzhou Secote Precision ElectronicLTD's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Zooming out, Suzhou Secote Precision ElectronicLTD seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Be aware that Suzhou Secote Precision ElectronicLTD is showing 1 warning sign in our investment analysis , you should know about...

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.