Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Cherish Sunshine International Limited (HKG:1094) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Cherish Sunshine International

What Is Cherish Sunshine International's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Cherish Sunshine International had HK$150.5m of debt, an increase on HK$70.5m, over one year. However, it does have HK$44.1m in cash offsetting this, leading to net debt of about HK$106.4m.

A Look At Cherish Sunshine International's Liabilities

We can see from the most recent balance sheet that Cherish Sunshine International had liabilities of HK$336.7m falling due within a year, and liabilities of HK$64.2m due beyond that. Offsetting these obligations, it had cash of HK$44.1m as well as receivables valued at HK$116.8m due within 12 months. So it has liabilities totalling HK$240.0m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$242.9m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 13.0 hit our confidence in Cherish Sunshine International like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Cherish Sunshine International achieved a positive EBIT of HK$7.3m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Cherish Sunshine International will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Cherish Sunshine International actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

To be frank both Cherish Sunshine International's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Cherish Sunshine International stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. We've identified 3 warning signs with Cherish Sunshine International , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.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.