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.'  It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses.  We can see that $CHINA RAILWAY (00390.HK)$ does use debt in its business.  But is this debt a concern to shareholders?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control.  Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage.  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 China Railway Construction

How Much Debt Does China Railway Construction Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 China Railway Construction had CN¥317.4b of debt, an increase on CN¥254.7b, over one year.    On the flip side, it has CN¥153.9b in cash leading to net debt of about CN¥163.5b.

SHSE:601186 Debt to Equity History September 19th 2022

How Strong Is China Railway Construction's Balance Sheet?

According to the last reported balance sheet, China Railway Construction had liabilities of CN¥924.5b due within 12 months, and liabilities of CN¥205.6b due beyond 12 months.   Offsetting these obligations, it had cash of CN¥153.9b as well as receivables valued at CN¥499.0b due within 12 months.   So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥477.2b.

This deficit casts a shadow over the CN¥91.3b company, like a colossus towering over mere mortals.   So we definitely think shareholders need to watch this one closely.  After all, China Railway Construction would likely require a major re-capitalisation if it had to pay its creditors today.

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.

China Railway Construction has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business.  But its EBIT was about 16.1 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign.        One way China Railway Construction could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year.      When analysing debt levels, the balance sheet is the obvious place to start.  But ultimately the future profitability of the business will decide if China Railway Construction 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits.   So we always check how much of that EBIT is translated into free cash flow.    Considering the last three years, China Railway Construction actually recorded a cash outflow, overall.  Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both China Railway Construction's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels.    But on the bright side, its interest cover is a good sign, and makes us more optimistic.      Overall, it seems to us that China Railway Construction's balance sheet is really quite a risk to the business.  So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say.    When analysing debt levels, the balance sheet is the obvious place to start.  However, not all investment risk resides within the balance sheet - far from it.     We've identified 2 warning signs with China Railway Construction (at least 1 which can't be ignored)  , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.