Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Mulsanne Group Holding Limited (HKG:1817) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Mulsanne Group Holding

What Is Mulsanne Group Holding's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Mulsanne Group Holding had CN¥1.60b of debt, an increase on CN¥1.49b, over one year. However, it also had CN¥220.9m in cash, and so its net debt is CN¥1.38b.

A Look At Mulsanne Group Holding's Liabilities

According to the last reported balance sheet, Mulsanne Group Holding had liabilities of CN¥1.54b due within 12 months, and liabilities of CN¥785.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥220.9m as well as receivables valued at CN¥431.3m due within 12 months. So it has liabilities totalling CN¥1.68b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥1.45b, we think shareholders really should watch Mulsanne Group Holding's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Mulsanne Group Holding shareholders face the double whammy of a high net debt to EBITDA ratio (19.6), and fairly weak interest coverage, since EBIT is just 0.74 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Mulsanne Group Holding is that it turned last year's EBIT loss into a gain of CN¥14m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Mulsanne Group Holding'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Mulsanne Group Holding actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Mulsanne Group Holding's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Mulsanne Group Holding stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Mulsanne Group Holding is showing 2 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.