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 Toly Bread Co.,Ltd. (SHSE:603866) 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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Toly BreadLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Toly BreadLtd had CN¥1.02b of debt, an increase on CN¥601.7m, over one year. However, it also had CN¥248.9m in cash, and so its net debt is CN¥771.3m.

A Look At Toly BreadLtd's Liabilities

The latest balance sheet data shows that Toly BreadLtd had liabilities of CN¥1.05b due within a year, and liabilities of CN¥906.0m falling due after that. Offsetting this, it had CN¥248.9m in cash and CN¥610.1m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.10b more than its cash and near-term receivables, combined.

Since publicly traded Toly BreadLtd shares are worth a total of CN¥10.8b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Toly BreadLtd has a low net debt to EBITDA ratio of only 0.87. And its EBIT easily covers its interest expense, being 33.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Toly BreadLtd saw its EBIT decline by 10.0% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Toly BreadLtd 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Toly BreadLtd reported free cash flow worth 2.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Toly BreadLtd's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Toly BreadLtd'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. 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. To that end, you should be aware of the 1 warning sign we've spotted with Toly BreadLtd .

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.