Brilliance Technology (SZSE:300542) Takes On Some Risk With Its Use Of Debt

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.' 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 Brilliance Technology Co., Ltd. (SZSE:300542) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Brilliance Technology

What Is Brilliance Technology's Net Debt?

As you can see below, at the end of March 2024, Brilliance Technology had CN¥376.3m of debt, up from CN¥307.0m a year ago. Click the image for more detail. However, it also had CN¥229.6m in cash, and so its net debt is CN¥146.7m.

A Look At Brilliance Technology's Liabilities

According to the last reported balance sheet, Brilliance Technology had liabilities of CN¥765.2m due within 12 months, and liabilities of CN¥1.23m due beyond 12 months. Offsetting this, it had CN¥229.6m in cash and CN¥600.7m in receivables that were due within 12 months. So it actually has CN¥63.9m more liquid assets than total liabilities.

This state of affairs indicates that Brilliance Technology'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¥3.72b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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.

Brilliance Technology has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.2 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Brilliance Technology saw its EBIT slide 8.7% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Brilliance 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Brilliance Technology 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

Brilliance Technology's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its level of total liabilities is relatively strong. When we consider all the factors discussed, it seems to us that Brilliance Technology is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Brilliance Technology is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.

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