Is Western Superconducting Technologies (SHSE:688122) Using Too Much 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Western Superconducting Technologies Co., Ltd. (SHSE:688122) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Western Superconducting Technologies

What Is Western Superconducting Technologies's Net Debt?

The chart below, which you can click on for greater detail, shows that Western Superconducting Technologies had CN¥2.64b in debt in September 2024; about the same as the year before. However, because it has a cash reserve of CN¥2.11b, its net debt is less, at about CN¥533.5m.

How Healthy Is Western Superconducting Technologies' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Western Superconducting Technologies had liabilities of CN¥4.26b due within 12 months and liabilities of CN¥1.34b due beyond that. Offsetting this, it had CN¥2.11b in cash and CN¥4.00b in receivables that were due within 12 months. So it actually has CN¥513.6m more liquid assets than total liabilities.

This state of affairs indicates that Western Superconducting Technologies' 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¥28.5b 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Western Superconducting Technologies's net debt is only 0.57 times its EBITDA. And its EBIT easily covers its interest expense, being 16.1 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Western Superconducting Technologies saw its EBIT decline by 7.3% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Western Superconducting Technologies 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Western Superconducting Technologies recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

On our analysis Western Superconducting Technologies's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. Looking at all this data makes us feel a little cautious about Western Superconducting Technologies'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. Be aware that Western Superconducting Technologies is showing 2 warning signs in our investment analysis , 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.