Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Xinya Electronic Co., Ltd. (SHSE:605277) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Xinya Electronic's Net Debt?

As you can see below, at the end of September 2023, Xinya Electronic had CN¥756.1m of debt, up from CN¥130.0m a year ago. Click the image for more detail. On the flip side, it has CN¥248.1m in cash leading to net debt of about CN¥508.1m.

How Healthy Is Xinya Electronic's Balance Sheet?

We can see from the most recent balance sheet that Xinya Electronic had liabilities of CN¥1.04b falling due within a year, and liabilities of CN¥507.1m due beyond that. Offsetting this, it had CN¥248.1m in cash and CN¥836.0m in receivables that were due within 12 months. So it has liabilities totalling CN¥461.1m more than its cash and near-term receivables, combined.

Since publicly traded Xinya Electronic shares are worth a total of CN¥4.11b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

We'd say that Xinya Electronic's moderate net debt to EBITDA ratio ( being 2.3), indicates prudence when it comes to debt. And its strong interest cover of 24.9 times, makes us even more comfortable. Also relevant is that Xinya Electronic has grown its EBIT by a very respectable 21% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xinya Electronic 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. In the last three years, Xinya Electronic's free cash flow amounted to 46% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Xinya Electronic's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! When we consider the range of factors above, it looks like Xinya Electronic is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Xinya Electronic you should know about.

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.

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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.