Here's Why Guangdong Topstar Technology (SZSE:300607) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Guangdong Topstar Technology Co., Ltd. (SZSE:300607) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Guangdong Topstar Technology

What Is Guangdong Topstar Technology's Net Debt?

As you can see below, Guangdong Topstar Technology had CN¥1.52b of debt at September 2024, down from CN¥1.72b a year prior. However, it does have CN¥1.16b in cash offsetting this, leading to net debt of about CN¥360.0m.

How Healthy Is Guangdong Topstar Technology's Balance Sheet?

The latest balance sheet data shows that Guangdong Topstar Technology had liabilities of CN¥3.04b due within a year, and liabilities of CN¥913.5m falling due after that. On the other hand, it had cash of CN¥1.16b and CN¥2.49b worth of receivables due within a year. So it has liabilities totalling CN¥305.9m more than its cash and near-term receivables, combined.

Since publicly traded Guangdong Topstar Technology shares are worth a total of CN¥9.60b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Guangdong Topstar Technology shareholders face the double whammy of a high net debt to EBITDA ratio (5.3), and fairly weak interest coverage, since EBIT is just 0.61 times the interest expense. The debt burden here is substantial. Even worse, Guangdong Topstar Technology saw its EBIT tank 89% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Guangdong Topstar 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Guangdong Topstar 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

On the face of it, Guangdong Topstar Technology's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Overall, it seems to us that Guangdong Topstar Technology's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Guangdong Topstar Technology 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.