Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Guangdong Tloong Technology Group Co.,Ltd (SZSE:300063) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Guangdong Tloong Technology GroupLtd

How Much Debt Does Guangdong Tloong Technology GroupLtd Carry?

As you can see below, Guangdong Tloong Technology GroupLtd had CN¥674.0m of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥174.9m in cash offsetting this, leading to net debt of about CN¥499.1m.

A Look At Guangdong Tloong Technology GroupLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Guangdong Tloong Technology GroupLtd had liabilities of CN¥1.36b due within 12 months and liabilities of CN¥111.3m due beyond that. Offsetting this, it had CN¥174.9m in cash and CN¥2.01b in receivables that were due within 12 months. So it actually has CN¥719.6m more liquid assets than total liabilities.

This excess liquidity suggests that Guangdong Tloong Technology GroupLtd is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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). 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).

Guangdong Tloong Technology GroupLtd shareholders face the double whammy of a high net debt to EBITDA ratio (5.4), and fairly weak interest coverage, since EBIT is just 2.1 times the interest expense. The debt burden here is substantial. Worse, Guangdong Tloong Technology GroupLtd's EBIT was down 46% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Guangdong Tloong Technology GroupLtd'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Guangdong Tloong Technology GroupLtd recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Guangdong Tloong Technology GroupLtd's net debt to EBITDA makes us cautious about it, its track record of (not) growing its EBIT is no better. But its not so bad at staying on top of its total liabilities. When we consider all the factors discussed, it seems to us that Guangdong Tloong Technology GroupLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Guangdong Tloong Technology GroupLtd is showing 3 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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.