Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that SUNeVision Holdings Ltd. (HKG:1686) uses debt in his business. But the more important question is: what risk does this debt create?

When is debt a problem?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for SUNeVision Holdings

How much debt does SUNeVision Holdings have?

The image below, which you can click on for more details, shows that as of December 2021, SUNeVision Holdings had HK$11.4 billion in debt, up from HK$10.5 billion in one year. However, since it has a cash reserve of HK$332.7 million, its net debt is lower at around HK$11.1 billion.

How strong is SUNeVision Holdings’ balance sheet?

We can see from the most recent balance sheet that SUNeVision Holdings had liabilities of HK$3.11 billion due within one year, and liabilities of HK$9.73 billion due beyond. As compensation for these obligations, it had liquid assets of HK$332.7 million as well as receivables valued at HK$446.8 million and payable within 12 months. It therefore has liabilities totaling HK$12.1 billion more than its cash and short-term receivables, combined.

This shortfall is not that bad as SUNeVision Holdings is worth HK$26.2 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without depreciation and amortization charges.

Strangely, SUNeVision Holdings has an exorbitant EBITDA ratio of 9.0, which implies high debt, but high interest coverage of 145. So either it has access to very cheap long-term debt, or interest expense will increase! SUNeVision Holdings increased its EBIT by 6.9% over the past year. While that barely brings us down, it’s a positive when it comes to debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine SUNeVision Holdings’ ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, SUNeVision Holdings has experienced substantial negative free cash flow, in total. While investors no doubt expect a reversal of this situation in due course, this clearly means that its use of debt is more risky.

Our point of view

To be frank, SUNeVision Holdings’ net debt to EBITDA ratio and history of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. But on the bright side, its interest coverage is a good sign and makes us more optimistic. Looking at the balance sheet and taking all of these factors into account, we think the debt makes SUNeVision Holdings stock a bit risky. Some people like that kind of risk, but we’re aware of the potential pitfalls, so we’d probably prefer it to take on less debt. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. Be aware that SUNeVision Holdings displays 2 warning signs in our investment analysis you should know…

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.