These 4 Measures Indicate That Sichuan Development LomonLtd (SZSE:002312) Is Using Debt Reasonably Well

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 Sichuan Development Lomon Co.,Ltd. (SZSE:002312) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sichuan Development LomonLtd

What Is Sichuan Development LomonLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Sichuan Development LomonLtd had debt of CN¥5.20b, up from CN¥4.70b in one year. On the flip side, it has CN¥3.61b in cash leading to net debt of about CN¥1.59b.

How Strong Is Sichuan Development LomonLtd's Balance Sheet?

We can see from the most recent balance sheet that Sichuan Development LomonLtd had liabilities of CN¥6.14b falling due within a year, and liabilities of CN¥2.93b due beyond that. Offsetting these obligations, it had cash of CN¥3.61b as well as receivables valued at CN¥709.3m due within 12 months. So its liabilities total CN¥4.76b more than the combination of its cash and short-term receivables.

Given Sichuan Development LomonLtd has a market capitalization of CN¥24.5b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Sichuan Development LomonLtd's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. And we also note warmly that Sichuan Development LomonLtd grew its EBIT by 10% last year, making its debt load easier to handle. 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 Sichuan Development LomonLtd'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Sichuan Development LomonLtd created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Sichuan Development LomonLtd was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Sichuan Development LomonLtd is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Sichuan Development LomonLtd (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.