Is Rainbow Digital Commercial (SZSE:002419) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Rainbow Digital Commercial Co., Ltd. (SZSE:002419) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Rainbow Digital Commercial

What Is Rainbow Digital Commercial's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Rainbow Digital Commercial had CN¥380.2m of debt, an increase on none, over one year. But it also has CN¥3.07b in cash to offset that, meaning it has CN¥2.69b net cash.

How Healthy Is Rainbow Digital Commercial's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rainbow Digital Commercial had liabilities of CN¥11.0b due within 12 months and liabilities of CN¥11.5b due beyond that. Offsetting these obligations, it had cash of CN¥3.07b as well as receivables valued at CN¥369.1m due within 12 months. So it has liabilities totalling CN¥19.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥5.83b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Rainbow Digital Commercial would probably need a major re-capitalization if its creditors were to demand repayment. Given that Rainbow Digital Commercial has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

On the other hand, Rainbow Digital Commercial saw its EBIT drop by 8.8% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder 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 Rainbow Digital Commercial'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Rainbow Digital Commercial 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. Over the last three years, Rainbow Digital Commercial actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While Rainbow Digital Commercial does have more liabilities than liquid assets, it also has net cash of CN¥2.69b. And it impressed us with free cash flow of CN¥1.3b, being 1,780% of its EBIT. So while Rainbow Digital Commercial does not have a great balance sheet, it's certainly not too bad. 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 Rainbow Digital Commercial that 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.