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 Gettop Acoustic Co., Ltd. (SZSE:002655) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Gettop Acoustic's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Gettop Acoustic had debt of CN¥340.6m, up from CN¥248.2m in one year. However, it does have CN¥172.2m in cash offsetting this, leading to net debt of about CN¥168.5m.

A Look At Gettop Acoustic's Liabilities

The latest balance sheet data shows that Gettop Acoustic had liabilities of CN¥756.1m due within a year, and liabilities of CN¥77.6m falling due after that. Offsetting this, it had CN¥172.2m in cash and CN¥534.9m in receivables that were due within 12 months. So its liabilities total CN¥126.7m more than the combination of its cash and short-term receivables.

Given Gettop Acoustic has a market capitalization of CN¥4.38b, it's hard to believe these liabilities pose much threat. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Gettop Acoustic's net debt is only 0.94 times its EBITDA. And its EBIT covers its interest expense a whopping 19.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Gettop Acoustic grew its EBIT by 355% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is Gettop Acoustic's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Gettop Acoustic recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Gettop Acoustic's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Zooming out, Gettop Acoustic seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Gettop Acoustic, you may well want to click here to check an interactive graph of its earnings per share history.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.