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, Funeng Oriental Equipment Technology Co., Ltd. (SZSE:300173) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Funeng Oriental Equipment Technology's Net Debt?

As you can see below, at the end of September 2024, Funeng Oriental Equipment Technology had CN¥996.1m of debt, up from CN¥408.1m a year ago. Click the image for more detail. However, it also had CN¥139.9m in cash, and so its net debt is CN¥856.2m.

How Strong Is Funeng Oriental Equipment Technology's Balance Sheet?

According to the last reported balance sheet, Funeng Oriental Equipment Technology had liabilities of CN¥2.79b due within 12 months, and liabilities of CN¥355.5m due beyond 12 months. Offsetting this, it had CN¥139.9m in cash and CN¥646.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥2.36b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Funeng Oriental Equipment Technology is worth CN¥4.25b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 17.1, it's fair to say Funeng Oriental Equipment Technology does have a significant amount of debt. However, its interest coverage of 6.7 is reasonably strong, which is a good sign. We also note that Funeng Oriental Equipment Technology improved its EBIT from a last year's loss to a positive CN¥32m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Funeng Oriental Equipment Technology 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Funeng Oriental Equipment Technology burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Funeng Oriental Equipment Technology's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Funeng Oriental Equipment Technology'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Funeng Oriental Equipment Technology has 3 warning signs (and 2 which can't be ignored) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.