These 4 Measures Indicate That Xiamen Leading Optics (SHSE:605118) Is Using Debt Safely

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 can see that Xiamen Leading Optics Co., Ltd. (SHSE:605118) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, 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.

View our latest analysis for Xiamen Leading Optics

What Is Xiamen Leading Optics's Debt?

As you can see below, at the end of September 2024, Xiamen Leading Optics had CN¥99.7m of debt, up from CN¥14.0m a year ago. Click the image for more detail. But on the other hand it also has CN¥590.8m in cash, leading to a CN¥491.1m net cash position.

How Strong Is Xiamen Leading Optics' Balance Sheet?

We can see from the most recent balance sheet that Xiamen Leading Optics had liabilities of CN¥241.5m falling due within a year, and liabilities of CN¥39.7m due beyond that. Offsetting these obligations, it had cash of CN¥590.8m as well as receivables valued at CN¥116.7m due within 12 months. So it can boast CN¥426.4m more liquid assets than total liabilities.

This surplus suggests that Xiamen Leading Optics has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Xiamen Leading Optics has more cash than debt is arguably a good indication that it can manage its debt safely.

Another good sign is that Xiamen Leading Optics has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Xiamen Leading Optics's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Xiamen Leading Optics 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. During the last three years, Xiamen Leading Optics generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case Xiamen Leading Optics has CN¥491.1m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥182m, being 80% of its EBIT. So is Xiamen Leading Optics's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Xiamen Leading Optics is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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.