David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Kunshan Asia Aroma Corp., Ltd. (SZSE:301220) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Kunshan Asia Aroma's Net Debt?

As you can see below, at the end of September 2024, Kunshan Asia Aroma had CN¥230.1m of debt, up from CN¥144.8m a year ago. Click the image for more detail. However, it also had CN¥227.9m in cash, and so its net debt is CN¥2.23m.

A Look At Kunshan Asia Aroma's Liabilities

According to the last reported balance sheet, Kunshan Asia Aroma had liabilities of CN¥374.1m due within 12 months, and liabilities of CN¥55.2m due beyond 12 months. Offsetting these obligations, it had cash of CN¥227.9m as well as receivables valued at CN¥246.1m due within 12 months. So it actually has CN¥44.7m more liquid assets than total liabilities.

This state of affairs indicates that Kunshan Asia Aroma'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¥3.82b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Kunshan Asia Aroma 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With debt at a measly 0.023 times EBITDA and EBIT covering interest a whopping 12.6 times, it's clear that Kunshan Asia Aroma is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. It is just as well that Kunshan Asia Aroma's load is not too heavy, because its EBIT was down 42% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Kunshan Asia Aroma's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Kunshan Asia Aroma burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We feel some trepidation about Kunshan Asia Aroma's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Kunshan Asia Aroma is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 3 warning signs for Kunshan Asia Aroma you should be aware of, and 1 of them shouldn't be ignored.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.