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 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. We note that Fujian Acetron New Materials Co., Ltd. (SZSE:300706) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Fujian Acetron New Materials's Debt?

As you can see below, at the end of September 2024, Fujian Acetron New Materials had CN¥776.2m of debt, up from CN¥624.2m a year ago. Click the image for more detail. On the flip side, it has CN¥294.4m in cash leading to net debt of about CN¥481.8m.

A Look At Fujian Acetron New Materials' Liabilities

The latest balance sheet data shows that Fujian Acetron New Materials had liabilities of CN¥962.2m due within a year, and liabilities of CN¥90.0m falling due after that. Offsetting these obligations, it had cash of CN¥294.4m as well as receivables valued at CN¥224.0m due within 12 months. So its liabilities total CN¥533.8m more than the combination of its cash and short-term receivables.

Since publicly traded Fujian Acetron New Materials shares are worth a total of CN¥4.13b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Fujian Acetron New Materials like a one-two punch to the gut. The debt burden here is substantial. Even more troubling is the fact that Fujian Acetron New Materials actually let its EBIT decrease by 3.5% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Fujian Acetron New Materials 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, 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. Over the last three years, Fujian Acetron New Materials saw substantial negative free cash flow, in total. 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

To be frank both Fujian Acetron New Materials's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Looking at the bigger picture, it seems clear to us that Fujian Acetron New Materials's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. To that end, you should learn about the 3 warning signs we've spotted with Fujian Acetron New Materials (including 1 which is a bit unpleasant) .

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.