Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Suzhou SONAVOX Electronics Co.,Ltd. (SHSE:688533) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Suzhou SONAVOX ElectronicsLtd Carry?

As you can see below, at the end of September 2023, Suzhou SONAVOX ElectronicsLtd had CN¥877.7m of debt, up from CN¥581.7m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥703.8m, its net debt is less, at about CN¥173.9m.

How Healthy Is Suzhou SONAVOX ElectronicsLtd's Balance Sheet?

The latest balance sheet data shows that Suzhou SONAVOX ElectronicsLtd had liabilities of CN¥925.0m due within a year, and liabilities of CN¥570.7m falling due after that. Offsetting these obligations, it had cash of CN¥703.8m as well as receivables valued at CN¥787.8m due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to Suzhou SONAVOX ElectronicsLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥4.20b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Suzhou SONAVOX ElectronicsLtd has a low net debt to EBITDA ratio of only 0.77. And its EBIT covers its interest expense a whopping 23.2 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Suzhou SONAVOX ElectronicsLtd grew its EBIT by 235% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Suzhou SONAVOX ElectronicsLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Suzhou SONAVOX ElectronicsLtd saw substantial negative free cash flow, in total. 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

Happily, Suzhou SONAVOX ElectronicsLtd's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Suzhou SONAVOX ElectronicsLtd can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Suzhou SONAVOX ElectronicsLtd that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.