The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Lizhong Sitong Light Alloys Group Co., Ltd. (SZSE:300428) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. By replacing dilution, though, debt can be an extremely good tool for businesses 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.

View our latest analysis for Lizhong Sitong Light Alloys Group

How Much Debt Does Lizhong Sitong Light Alloys Group Carry?

As you can see below, at the end of March 2022, Lizhong Sitong Light Alloys Group had CN¥6.61b of debt, up from CN¥4.25b a year ago. Click the image for more detail. However, it does have CN¥2.12b in cash offsetting this, leading to net debt of about CN¥4.49b.

How Healthy Is Lizhong Sitong Light Alloys Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Lizhong Sitong Light Alloys Group had liabilities of CN¥8.38b due within 12 months and liabilities of CN¥1.35b due beyond that. On the other hand, it had cash of CN¥2.12b and CN¥5.05b worth of receivables due within a year. So it has liabilities totalling CN¥2.56b more than its cash and near-term receivables, combined.

Of course, Lizhong Sitong Light Alloys Group has a market capitalization of CN¥21.6b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Lizhong Sitong Light Alloys Group's debt is 4.6 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Lizhong Sitong Light Alloys Group saw its EBIT drop by 9.9% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lizhong Sitong Light Alloys Group 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.

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 that EBIT is backed by free cash flow. During the last three years, Lizhong Sitong Light Alloys Group burned a lot of cash. 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

Mulling over Lizhong Sitong Light Alloys Group's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Lizhong Sitong Light Alloys Group has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Lizhong Sitong Light Alloys Group you should be aware of, and 2 of them are potentially serious.

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.