Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Sinomach Precision Industry Group Co., Ltd. (SZSE:002046) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Sinomach Precision Industry Group's Net Debt?

The image below, which you can click on for greater detail, shows that Sinomach Precision Industry Group had debt of CN¥815.0m at the end of September 2024, a reduction from CN¥930.5m over a year. However, because it has a cash reserve of CN¥551.5m, its net debt is less, at about CN¥263.5m.

A Look At Sinomach Precision Industry Group's Liabilities

The latest balance sheet data shows that Sinomach Precision Industry Group had liabilities of CN¥1.42b due within a year, and liabilities of CN¥661.1m falling due after that. Offsetting these obligations, it had cash of CN¥551.5m as well as receivables valued at CN¥1.53b due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

Having regard to Sinomach Precision Industry Group's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥8.15b company is short on cash, but still worth keeping an eye on the balance sheet.

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).

Sinomach Precision Industry Group's net debt is only 0.79 times its EBITDA. And its EBIT easily covers its interest expense, being 14.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Sinomach Precision Industry Group has seen its EBIT plunge 10% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sinomach Precision Industry Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Sinomach Precision Industry Group created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Sinomach Precision Industry Group was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to grow its EBIT. Considering this range of data points, we think Sinomach Precision Industry Group is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Sinomach Precision Industry Group , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.