Daoming Optics&ChemicalLtd (SZSE:002632) Could Easily Take On More Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Daoming Optics&Chemical Co.,Ltd (SZSE:002632) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Daoming Optics&ChemicalLtd Carry?

The image below, which you can click on for greater detail, shows that Daoming Optics&ChemicalLtd had debt of CN¥250.2m at the end of September 2024, a reduction from CN¥416.8m over a year. However, its balance sheet shows it holds CN¥654.3m in cash, so it actually has CN¥404.1m net cash.

How Strong Is Daoming Optics&ChemicalLtd's Balance Sheet?

The latest balance sheet data shows that Daoming Optics&ChemicalLtd had liabilities of CN¥608.3m due within a year, and liabilities of CN¥27.0m falling due after that. Offsetting this, it had CN¥654.3m in cash and CN¥382.3m in receivables that were due within 12 months. So it can boast CN¥401.4m more liquid assets than total liabilities.

This surplus suggests that Daoming Optics&ChemicalLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Daoming Optics&ChemicalLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

See our latest analysis for Daoming Optics&ChemicalLtd

In addition to that, we're happy to report that Daoming Optics&ChemicalLtd has boosted its EBIT by 53%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is Daoming Optics&ChemicalLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Daoming Optics&ChemicalLtd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Daoming Optics&ChemicalLtd generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Daoming Optics&ChemicalLtd has CN¥404.1m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in CN¥246m. So is Daoming Optics&ChemicalLtd's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 2 warning signs for Daoming Optics&ChemicalLtd that 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.

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.