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.' 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. We note that Anhui Truchum Advanced Materials and Technology Co., Ltd. (SZSE:002171) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Anhui Truchum Advanced Materials and Technology's Debt?

As you can see below, at the end of September 2023, Anhui Truchum Advanced Materials and Technology had CN¥7.84b of debt, up from CN¥6.18b a year ago. Click the image for more detail. However, it does have CN¥2.32b in cash offsetting this, leading to net debt of about CN¥5.52b.

How Healthy Is Anhui Truchum Advanced Materials and Technology's Balance Sheet?

According to the last reported balance sheet, Anhui Truchum Advanced Materials and Technology had liabilities of CN¥7.33b due within 12 months, and liabilities of CN¥2.58b due beyond 12 months. On the other hand, it had cash of CN¥2.32b and CN¥4.46b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.13b.

This deficit isn't so bad because Anhui Truchum Advanced Materials and Technology is worth CN¥9.62b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 8.1, it's fair to say Anhui Truchum Advanced Materials and Technology does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.4 times, suggesting it can responsibly service its obligations. The good news is that Anhui Truchum Advanced Materials and Technology grew its EBIT a smooth 46% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Anhui Truchum Advanced Materials and Technology 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Anhui Truchum Advanced Materials and Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Anhui Truchum Advanced Materials and Technology's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Anhui Truchum Advanced Materials and Technology's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Anhui Truchum Advanced Materials and Technology (1 is concerning) you should be aware of.

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.