Is Lingyi iTech (Guangdong) (SZSE:002600) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Lingyi iTech (Guangdong) Company (SZSE:002600) does carry debt. But should shareholders be worried about its use of debt?

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When Is Debt Dangerous?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Lingyi iTech (Guangdong)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that Lingyi iTech (Guangdong) had CN¥7.38b of debt in September 2024, down from CN¥9.01b, one year before. However, it also had CN¥3.70b in cash, and so its net debt is CN¥3.69b.

How Healthy Is Lingyi iTech (Guangdong)'s Balance Sheet?

According to the last reported balance sheet, Lingyi iTech (Guangdong) had liabilities of CN¥14.6b due within 12 months, and liabilities of CN¥7.52b due beyond 12 months. On the other hand, it had cash of CN¥3.70b and CN¥11.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.87b.

Since publicly traded Lingyi iTech (Guangdong) shares are worth a total of CN¥63.7b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

See our latest analysis for Lingyi iTech (Guangdong)

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Lingyi iTech (Guangdong) has a low net debt to EBITDA ratio of only 0.94. And its EBIT covers its interest expense a whopping 14.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Lingyi iTech (Guangdong)'s saving grace is its low debt levels, because its EBIT has tanked 32% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Lingyi iTech (Guangdong) 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Lingyi iTech (Guangdong)'s free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Based on what we've seen Lingyi iTech (Guangdong) is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Lingyi iTech (Guangdong)'s use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Lingyi iTech (Guangdong) , 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.