Here's Why Guangdong Dowstone Technology (SZSE:300409) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Guangdong Dowstone Technology Co., Ltd. (SZSE:300409) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Guangdong Dowstone Technology

What Is Guangdong Dowstone Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Guangdong Dowstone Technology had CN¥5.81b of debt, an increase on CN¥4.33b, over one year. However, it also had CN¥3.92b in cash, and so its net debt is CN¥1.90b.

How Strong Is Guangdong Dowstone Technology's Balance Sheet?

The latest balance sheet data shows that Guangdong Dowstone Technology had liabilities of CN¥4.23b due within a year, and liabilities of CN¥3.62b falling due after that. On the other hand, it had cash of CN¥3.92b and CN¥2.39b worth of receivables due within a year. So its liabilities total CN¥1.55b more than the combination of its cash and short-term receivables.

Guangdong Dowstone Technology has a market capitalization of CN¥5.69b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Guangdong Dowstone Technology's debt to EBITDA ratio (3.7) suggests that it uses some debt, its interest cover is very weak, at 1.1, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Guangdong Dowstone Technology actually grew its EBIT by a hefty 1,740%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Guangdong Dowstone Technology will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Guangdong Dowstone Technology saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Guangdong Dowstone Technology's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Guangdong Dowstone Technology is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Guangdong Dowstone Technology is showing 4 warning signs in our investment analysis , and 2 of those are potentially serious...

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.