Is Sinoma Science & TechnologyLtd (SZSE:002080) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Sinoma Science & Technology Co.,Ltd. (SZSE:002080) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Sinoma Science & TechnologyLtd

What Is Sinoma Science & TechnologyLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Sinoma Science & TechnologyLtd had debt of CN¥17.1b, up from CN¥15.0b in one year. However, it does have CN¥1.67b in cash offsetting this, leading to net debt of about CN¥15.4b.

How Strong Is Sinoma Science & TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sinoma Science & TechnologyLtd had liabilities of CN¥19.2b due within 12 months and liabilities of CN¥12.8b due beyond that. Offsetting these obligations, it had cash of CN¥1.67b as well as receivables valued at CN¥12.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.0b.

This deficit is considerable relative to its market capitalization of CN¥21.3b, so it does suggest shareholders should keep an eye on Sinoma Science & TechnologyLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.1, it's fair to say Sinoma Science & TechnologyLtd does have a significant amount of debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. Even worse, Sinoma Science & TechnologyLtd saw its EBIT tank 64% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sinoma Science & TechnologyLtd'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.

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 three years, Sinoma Science & TechnologyLtd 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

To be frank both Sinoma Science & TechnologyLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Sinoma Science & TechnologyLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example - Sinoma Science & TechnologyLtd has 4 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.