Here's Why Changchun UP OptotechLtd (SZSE:002338) Can Manage Its Debt Responsibly

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. As with many other companies Changchun UP Optotech Co.,Ltd. (SZSE:002338) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Changchun UP OptotechLtd

What Is Changchun UP OptotechLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Changchun UP OptotechLtd had CN¥236.9m of debt, an increase on CN¥144.2m, over one year. However, it also had CN¥95.0m in cash, and so its net debt is CN¥141.9m.

How Healthy Is Changchun UP OptotechLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Changchun UP OptotechLtd had liabilities of CN¥285.0m due within 12 months and liabilities of CN¥317.4m due beyond that. Offsetting this, it had CN¥95.0m in cash and CN¥423.4m in receivables that were due within 12 months. So it has liabilities totalling CN¥84.0m more than its cash and near-term receivables, combined.

This state of affairs indicates that Changchun UP OptotechLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥7.89b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Changchun UP OptotechLtd has a low debt to EBITDA ratio of only 0.80. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Even more impressive was the fact that Changchun UP OptotechLtd grew its EBIT by 281% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Changchun UP OptotechLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 last three years, Changchun UP OptotechLtd reported free cash flow worth 16% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Happily, Changchun UP OptotechLtd's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at the bigger picture, we think Changchun UP OptotechLtd's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Changchun UP OptotechLtd's earnings per share history for free.

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.