Qingdao Gon Technology (SZSE:002768) Takes On Some Risk With Its Use Of 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 note that Qingdao Gon Technology Co., Ltd. (SZSE:002768) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Qingdao Gon Technology

How Much Debt Does Qingdao Gon Technology Carry?

As you can see below, at the end of September 2024, Qingdao Gon Technology had CN¥4.77b of debt, up from CN¥3.99b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥3.09b, its net debt is less, at about CN¥1.68b.

How Strong Is Qingdao Gon Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Qingdao Gon Technology had liabilities of CN¥6.67b due within 12 months and liabilities of CN¥3.11b due beyond that. Offsetting this, it had CN¥3.09b in cash and CN¥4.05b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.64b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Qingdao Gon Technology has a market capitalization of CN¥5.79b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Qingdao Gon Technology's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 7.0 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly Qingdao Gon Technology's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Qingdao Gon Technology 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Qingdao Gon Technology 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

Mulling over Qingdao Gon Technology's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Qingdao Gon Technology stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 1 warning sign for Qingdao Gon Technology you should be aware of.

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.

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.