We Think Shenzhen FRD Science & Technology (SZSE:300602) Can Stay On Top Of Its Debt

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.

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Shenzhen FRD Science & Technology

What Is Shenzhen FRD Science & Technology's Net Debt?

The chart below, which you can click on for greater detail, shows that Shenzhen FRD Science & Technology had CN¥1.50b in debt in September 2024; about the same as the year before. On the flip side, it has CN¥1.37b in cash leading to net debt of about CN¥127.0m.

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

According to the last reported balance sheet, Shenzhen FRD Science & Technology had liabilities of CN¥2.91b due within 12 months, and liabilities of CN¥792.4m due beyond 12 months. On the other hand, it had cash of CN¥1.37b and CN¥2.16b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥163.9m.

Having regard to Shenzhen FRD Science & Technology's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥11.8b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Shenzhen FRD Science & Technology 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenzhen FRD Science & Technology has a low net debt to EBITDA ratio of only 0.32. And its EBIT covers its interest expense a whopping 11.2 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Shenzhen FRD Science & Technology grew its EBIT by 148% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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, 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 two years, Shenzhen FRD Science & Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, Shenzhen FRD Science & Technology's impressive EBIT growth rate 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. Looking at all the aforementioned factors together, it strikes us that Shenzhen FRD Science & Technology can handle its debt fairly comfortably. 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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 1 warning sign for Shenzhen FRD Science & Technology 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.