Is Dian Diagnostics GroupLtd (SZSE:300244) A Risky Investment?

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. We note that Dian Diagnostics Group Co.,Ltd. (SZSE:300244) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Dian Diagnostics GroupLtd Carry?

The image below, which you can click on for greater detail, shows that Dian Diagnostics GroupLtd had debt of CN¥3.78b at the end of September 2024, a reduction from CN¥4.12b over a year. However, because it has a cash reserve of CN¥1.73b, its net debt is less, at about CN¥2.05b.

How Healthy Is Dian Diagnostics GroupLtd's Balance Sheet?

The latest balance sheet data shows that Dian Diagnostics GroupLtd had liabilities of CN¥4.90b due within a year, and liabilities of CN¥2.70b falling due after that. Offsetting this, it had CN¥1.73b in cash and CN¥8.67b in receivables that were due within 12 months. So it actually has CN¥2.80b more liquid assets than total liabilities.

This excess liquidity suggests that Dian Diagnostics GroupLtd is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

Check out our latest analysis for Dian Diagnostics GroupLtd

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Dian Diagnostics GroupLtd's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Dian Diagnostics GroupLtd saw its EBIT tank 67% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dian Diagnostics GroupLtd'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Dian Diagnostics GroupLtd recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Dian Diagnostics GroupLtd's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its level of total liabilities. We would also note that Healthcare industry companies like Dian Diagnostics GroupLtd commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Dian Diagnostics GroupLtd's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 2 warning signs for Dian Diagnostics GroupLtd you should be aware of, and 1 of them makes us a bit uncomfortable.

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.