These 4 Measures Indicate That Rainbow Digital Commercial (SZSE:002419) Is Using Debt Extensively

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Rainbow Digital Commercial Co., Ltd. (SZSE:002419) does carry 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Rainbow Digital Commercial

What Is Rainbow Digital Commercial's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Rainbow Digital Commercial had debt of CN¥390.2m, up from none in one year. But it also has CN¥4.49b in cash to offset that, meaning it has CN¥4.10b net cash.

A Look At Rainbow Digital Commercial's Liabilities

Zooming in on the latest balance sheet data, we can see that Rainbow Digital Commercial had liabilities of CN¥10.8b due within 12 months and liabilities of CN¥12.0b due beyond that. Offsetting these obligations, it had cash of CN¥4.49b as well as receivables valued at CN¥281.4m due within 12 months. So it has liabilities totalling CN¥18.0b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥5.21b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. 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.

Unfortunately, Rainbow Digital Commercial's EBIT flopped 18% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Rainbow Digital Commercial has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. 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¥4.10b. The cherry on top was that in converted 1,701% of that EBIT to free cash flow, bringing in CN¥1.9b. Despite the cash, we do find Rainbow Digital Commercial's level of total liabilities concerning, so we're not particularly comfortable with the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Rainbow Digital Commercial that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.