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. Importantly, iRay Technology Company Limited (SHSE:688301) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
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What Is iRay Technology’s Net Debt?
As you can see below, at the end of September 2024, iRay Technology had CN¥2.88b of debt, up from CN¥1.40b a year ago. Click the image for more detail. On the flip side, it has CN¥1.69b in cash leading to net debt of about CN¥1.19b.
How Healthy Is iRay Technology’s Balance Sheet?
We can see from the most recent balance sheet that iRay Technology had liabilities of CN¥636.3m falling due within a year, and liabilities of CN¥2.97b due beyond that. On the other hand, it had cash of CN¥1.69b and CN¥881.5m worth of receivables due within a year. So its liabilities total CN¥1.03b more than the combination of its cash and short-term receivables.
Since publicly traded iRay Technology shares are worth a total of CN¥16.0b, 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.
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.
iRay Technology’s net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Shareholders should be aware that iRay Technology’s EBIT was down 24% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine iRay Technology’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, iRay Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Neither iRay Technology’s ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. It’s also worth noting that iRay Technology is in the Medical Equipment industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that iRay Technology is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 3 warning signs for iRay Technology (1 can’t be ignored) you should be aware of.
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.