Is Sunny Optical Technology (Group) (HKG:2382) Using Too Much Debt?

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.' 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 Sunny Optical Technology (Group) Company Limited (HKG:2382) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sunny Optical Technology (Group)

How Much Debt Does Sunny Optical Technology (Group) Carry?

The chart below, which you can click on for greater detail, shows that Sunny Optical Technology (Group) had CN¥6.05b in debt in December 2021; about the same as the year before. But it also has CN¥15.0b in cash to offset that, meaning it has CN¥8.99b net cash.

How Strong Is Sunny Optical Technology (Group)'s Balance Sheet?

We can see from the most recent balance sheet that Sunny Optical Technology (Group) had liabilities of CN¥11.9b falling due within a year, and liabilities of CN¥6.01b due beyond that. On the other hand, it had cash of CN¥15.0b and CN¥7.04b worth of receivables due within a year. So it can boast CN¥4.20b more liquid assets than total liabilities.

This short term liquidity is a sign that Sunny Optical Technology (Group) could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Sunny Optical Technology (Group) has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Sunny Optical Technology (Group) saw its EBIT drop by 2.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sunny Optical Technology (Group) can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Sunny Optical Technology (Group) 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. In the last three years, Sunny Optical Technology (Group)'s free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Sunny Optical Technology (Group) has net cash of CN¥8.99b, as well as more liquid assets than liabilities. So we don't have any problem with Sunny Optical Technology (Group)'s use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Sunny Optical Technology (Group) that you should be aware of before investing here.

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.