These 4 Measures Indicate That Shenzhen FRD Science & Technology (SZSE:300602) Is Using Debt Extensively

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 Shenzhen FRD Science & Technology Co., Ltd. (SZSE:300602) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shenzhen FRD Science & Technology

How Much Debt Does Shenzhen FRD Science & Technology Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Shenzhen FRD Science & Technology had debt of CN¥1.52b, up from CN¥1.31b in one year. On the flip side, it has CN¥1.40b in cash leading to net debt of about CN¥123.0m.

How Strong Is Shenzhen FRD Science & Technology's Balance Sheet?

The latest balance sheet data shows that Shenzhen FRD Science & Technology had liabilities of CN¥2.43b due within a year, and liabilities of CN¥1.16b falling due after that. Offsetting these obligations, it had cash of CN¥1.40b as well as receivables valued at CN¥1.82b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥365.3m.

Of course, Shenzhen FRD Science & Technology has a market capitalization of CN¥8.05b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Looking at its net debt to EBITDA of 0.50 and interest cover of 5.7 times, it seems to us that Shenzhen FRD Science & Technology is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. It was also good to see that despite losing money on the EBIT line last year, Shenzhen FRD Science & Technology turned things around in the last 12 months, delivering and EBIT of CN¥64m. 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 Shenzhen FRD Science & Technology'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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Shenzhen FRD Science & Technology burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shenzhen FRD Science & Technology's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its net debt to EBITDA was re-invigorating. We think that Shenzhen FRD Science & Technology's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Shenzhen FRD Science & Technology is showing 2 warning signs in our investment analysis , you should know about...

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.