Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Guangshen Railway Company Limited (HKG:525) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Guangshen Railway's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Guangshen Railway had debt of CN¥1.49b, up from CN¥700.0m in one year. However, because it has a cash reserve of CN¥1.43b, its net debt is less, at about CN¥56.5m.

How Healthy Is Guangshen Railway's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangshen Railway had liabilities of CN¥7.75b due within 12 months and liabilities of CN¥2.87b due beyond that. Offsetting these obligations, it had cash of CN¥1.43b as well as receivables valued at CN¥6.39b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.81b.

Given Guangshen Railway has a market capitalization of CN¥18.8b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Guangshen Railway has a very light debt load indeed.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Guangshen Railway has a net debt to EBITDA ratio of 0.029, suggesting a very conservative balance sheet. But strangely, EBIT was only 1.5 times interest expenses, suggesting the that may paint an overly pretty picture of the stock. Notably, Guangshen Railway made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥82m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guangshen Railway 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Guangshen Railway saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Both Guangshen Railway's conversion of EBIT to free cash flow and its interest cover were discouraging. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Guangshen Railway 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Guangshen Railway you should be aware of.

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.