Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Shenzhen Qingyi Photomask Limited (SHSE:688138) makes use of debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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, 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 Shenzhen Qingyi Photomask's Debt?

As you can see below, at the end of September 2024, Shenzhen Qingyi Photomask had CN¥851.2m of debt, up from CN¥206.0m a year ago. Click the image for more detail. On the flip side, it has CN¥476.6m in cash leading to net debt of about CN¥374.6m.

How Healthy Is Shenzhen Qingyi Photomask's Balance Sheet?

The latest balance sheet data shows that Shenzhen Qingyi Photomask had liabilities of CN¥778.1m due within a year, and liabilities of CN¥386.4m falling due after that. Offsetting these obligations, it had cash of CN¥476.6m as well as receivables valued at CN¥350.5m due within 12 months. So its liabilities total CN¥337.4m more than the combination of its cash and short-term receivables.

Of course, Shenzhen Qingyi Photomask has a market capitalization of CN¥6.07b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenzhen Qingyi Photomask has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 15.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Shenzhen Qingyi Photomask has boosted its EBIT by 47%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shenzhen Qingyi Photomask 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. During the last three years, Shenzhen Qingyi Photomask 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

Happily, Shenzhen Qingyi Photomask's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Shenzhen Qingyi Photomask can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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 instance, we've identified 2 warning signs for Shenzhen Qingyi Photomask (1 shouldn't be ignored) you should be aware of.

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.