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 can see that ShenZhen Woer Heat-Shrinkable Material Co.,Ltd. (SZSE:002130) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is ShenZhen Woer Heat-Shrinkable MaterialLtd's Net Debt?

As you can see below, ShenZhen Woer Heat-Shrinkable MaterialLtd had CN¥1.61b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥1.18b in cash leading to net debt of about CN¥421.6m.

How Strong Is ShenZhen Woer Heat-Shrinkable MaterialLtd's Balance Sheet?

According to the last reported balance sheet, ShenZhen Woer Heat-Shrinkable MaterialLtd had liabilities of CN¥2.63b due within 12 months, and liabilities of CN¥1.26b due beyond 12 months. On the other hand, it had cash of CN¥1.18b and CN¥3.02b worth of receivables due within a year. So it can boast CN¥313.4m more liquid assets than total liabilities.

Having regard to ShenZhen Woer Heat-Shrinkable MaterialLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥32.0b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, ShenZhen Woer Heat-Shrinkable MaterialLtd has a very light debt load indeed.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

ShenZhen Woer Heat-Shrinkable MaterialLtd has a low net debt to EBITDA ratio of only 0.32. And its EBIT covers its interest expense a whopping 61.6 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that ShenZhen Woer Heat-Shrinkable MaterialLtd has boosted its EBIT by 41%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ShenZhen Woer Heat-Shrinkable MaterialLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, ShenZhen Woer Heat-Shrinkable MaterialLtd recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that ShenZhen Woer Heat-Shrinkable MaterialLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that ShenZhen Woer Heat-Shrinkable MaterialLtd is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. 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. To that end, you should be aware of the 2 warning signs we've spotted with ShenZhen Woer Heat-Shrinkable MaterialLtd .

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.