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.' 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 East Asia Machinery Industrial Co., Ltd. (SZSE:301028) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Xiamen East Asia Machinery Industrial's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Xiamen East Asia Machinery Industrial had CN¥112.8m of debt, an increase on none, over one year. However, it does have CN¥513.2m in cash offsetting this, leading to net cash of CN¥400.4m.

A Look At Xiamen East Asia Machinery Industrial's Liabilities

According to the last reported balance sheet, Xiamen East Asia Machinery Industrial had liabilities of CN¥678.2m due within 12 months, and liabilities of CN¥131.4m due beyond 12 months. Offsetting these obligations, it had cash of CN¥513.2m as well as receivables valued at CN¥263.2m due within 12 months. So it has liabilities totalling CN¥33.2m more than its cash and near-term receivables, combined.

This state of affairs indicates that Xiamen East Asia Machinery Industrial's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥3.77b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Xiamen East Asia Machinery Industrial also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Xiamen East Asia Machinery Industrial has boosted its EBIT by 53%, thus reducing the spectre of future debt repayments. 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 East Asia Machinery Industrial 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. While Xiamen East Asia Machinery Industrial has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Xiamen East Asia Machinery Industrial produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Xiamen East Asia Machinery Industrial has CN¥400.4m in net cash. And it impressed us with its EBIT growth of 53% over the last year. So we don't think Xiamen East Asia Machinery Industrial's use of debt is risky. 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. We've identified 2 warning signs with Xiamen East Asia Machinery Industrial (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.