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.' 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. As with many other companies Xiamen Sunrise Group Co., Ltd. (SZSE:002593) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Xiamen Sunrise Group's Net Debt?

The image below, which you can click on for greater detail, shows that Xiamen Sunrise Group had debt of CN¥1.23b at the end of September 2024, a reduction from CN¥1.32b over a year. On the flip side, it has CN¥628.4m in cash leading to net debt of about CN¥597.9m.

How Strong Is Xiamen Sunrise Group's Balance Sheet?

According to the last reported balance sheet, Xiamen Sunrise Group had liabilities of CN¥1.84b due within 12 months, and liabilities of CN¥280.3m due beyond 12 months. On the other hand, it had cash of CN¥628.4m and CN¥1.06b worth of receivables due within a year. So it has liabilities totalling CN¥433.3m more than its cash and near-term receivables, combined.

Of course, Xiamen Sunrise Group has a market capitalization of CN¥4.08b, so these liabilities are probably manageable. 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).

Xiamen Sunrise Group's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The silver lining is that Xiamen Sunrise Group grew its EBIT by 196% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xiamen Sunrise 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Xiamen Sunrise Group's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for Xiamen Sunrise Group was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. When we consider all the elements mentioned above, it seems to us that Xiamen Sunrise Group is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Xiamen Sunrise Group (of which 2 shouldn't be ignored!) you should know about.

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.