We Think Xiamen Leading Optics (SHSE:605118) Can Stay On Top Of Its Debt

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Xiamen Leading Optics Co., Ltd. (SHSE:605118) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Xiamen Leading Optics

What Is Xiamen Leading Optics's Debt?

The image below, which you can click on for greater detail, shows that Xiamen Leading Optics had debt of CN¥13.2m at the end of March 2024, a reduction from CN¥14.8m over a year. However, it does have CN¥377.8m in cash offsetting this, leading to net cash of CN¥364.6m.

How Healthy Is Xiamen Leading Optics' Balance Sheet?

The latest balance sheet data shows that Xiamen Leading Optics had liabilities of CN¥120.0m due within a year, and liabilities of CN¥47.3m falling due after that. Offsetting this, it had CN¥377.8m in cash and CN¥104.0m in receivables that were due within 12 months. So it actually has CN¥314.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Xiamen Leading Optics could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Xiamen Leading Optics boasts net cash, so it's fair to say it does not have a heavy debt load!

Also positive, Xiamen Leading Optics grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Xiamen Leading Optics 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. Looking at the most recent three years, Xiamen Leading Optics recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Xiamen Leading Optics has net cash of CN¥364.6m, as well as more liquid assets than liabilities. And we liked the look of last year's 22% year-on-year EBIT growth. So is Xiamen Leading Optics's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Xiamen Leading Optics (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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.