These 4 Measures Indicate That Sinoma Science & TechnologyLtd (SZSE:002080) Is Using Debt Extensively

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 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?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

See our latest analysis for Sinoma Science & TechnologyLtd

What Is Sinoma Science & TechnologyLtd's Debt?

As you can see below, at the end of March 2024, Sinoma Science & TechnologyLtd had CN¥15.4b of debt, up from CN¥12.5b a year ago. Click the image for more detail. However, it does have CN¥1.77b in cash offsetting this, leading to net debt of about CN¥13.7b.

How Healthy 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¥18.8b due within 12 months and liabilities of CN¥12.6b due beyond that. On the other hand, it had cash of CN¥1.77b and CN¥13.3b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥16.3b.

This deficit is considerable relative to its market capitalization of CN¥18.0b, 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.

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.

Sinoma Science & TechnologyLtd has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Sinoma Science & TechnologyLtd's EBIT fell a jaw-dropping 24% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Sinoma Science & TechnologyLtd 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, Sinoma Science & TechnologyLtd'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 on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Sinoma Science & TechnologyLtd'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Sinoma Science & TechnologyLtd , and understanding them should be part of your investment process.

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.

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