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.' 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. Importantly, GD Power Development Co.,Ltd (SHSE:600795) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for GD Power DevelopmentLtd

How Much Debt Does GD Power DevelopmentLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 GD Power DevelopmentLtd had CN¥227.4b of debt, an increase on CN¥186.7b, over one year. However, because it has a cash reserve of CN¥14.6b, its net debt is less, at about CN¥212.8b.

How Strong Is GD Power DevelopmentLtd's Balance Sheet?

We can see from the most recent balance sheet that GD Power DevelopmentLtd had liabilities of CN¥126.5b falling due within a year, and liabilities of CN¥160.9b due beyond that. On the other hand, it had cash of CN¥14.6b and CN¥25.8b worth of receivables due within a year. So it has liabilities totalling CN¥247.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥65.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, GD Power DevelopmentLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 8.9 hit our confidence in GD Power DevelopmentLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, GD Power DevelopmentLtd's EBIT was down 77% 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if GD Power DevelopmentLtd 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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, GD Power DevelopmentLtd recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

To be frank both GD Power DevelopmentLtd's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that GD Power DevelopmentLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for GD Power DevelopmentLtd (of which 1 is concerning!) 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.