Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Guoco Group Limited (HKG:53) makes use of debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Guoco Group

What Is Guoco Group's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 Guoco Group had debt of US$5.34b, up from US$4.99b in one year. However, because it has a cash reserve of US$2.98b, its net debt is less, at about US$2.37b.

A Look At Guoco Group's Liabilities

According to the last reported balance sheet, Guoco Group had liabilities of US$1.69b due within 12 months, and liabilities of US$5.88b due beyond 12 months. On the other hand, it had cash of US$2.98b and US$3.39b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.20b.

While this might seem like a lot, it is not so bad since Guoco Group has a market capitalization of US$3.41b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Guoco Group's debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One redeeming factor for Guoco Group is that it turned last year's EBIT loss into a gain of US$365m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Guoco Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Guoco Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

When it comes to the balance sheet, the standout positive for Guoco Group was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at managing its debt, based on its EBITDA, as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Guoco Group's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 1 warning sign with Guoco Group , 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.

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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.