Here's Why Kunshan Asia Aroma (SZSE:301220) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 note that Kunshan Asia Aroma Corp., Ltd. (SZSE:301220) does have debt on its balance sheet. But is this debt a concern to shareholders?

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Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Kunshan Asia Aroma's Debt?

As you can see below, at the end of September 2024, Kunshan Asia Aroma had CN¥230.1m of debt, up from CN¥144.8m a year ago. Click the image for more detail. On the flip side, it has CN¥227.9m in cash leading to net debt of about CN¥2.23m.

How Healthy Is Kunshan Asia Aroma's Balance Sheet?

We can see from the most recent balance sheet that Kunshan Asia Aroma had liabilities of CN¥374.1m falling due within a year, and liabilities of CN¥55.2m due beyond that. Offsetting this, it had CN¥227.9m in cash and CN¥246.1m in receivables that were due within 12 months. So it can boast CN¥44.7m more liquid assets than total liabilities.

This state of affairs indicates that Kunshan Asia Aroma's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥5.94b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Kunshan Asia Aroma has virtually no net debt, so it's fair to say it does not have a heavy debt load!

See our latest analysis for Kunshan Asia Aroma

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

With debt at a measly 0.023 times EBITDA and EBIT covering interest a whopping 12.6 times, it's clear that Kunshan Asia Aroma is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. The modesty of its debt load may become crucial for Kunshan Asia Aroma if management cannot prevent a repeat of the 42% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kunshan Asia Aroma'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. Over the last three years, Kunshan Asia Aroma saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Kunshan Asia Aroma's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Kunshan Asia Aroma's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For instance, we've identified 3 warning signs for Kunshan Asia Aroma (2 are a bit unpleasant) you should be aware of.

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.

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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.