Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, China Railway Group Limited (SHSE:601390) does carry debt. But should shareholders be worried about its use of debt?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 China Railway Group

What Is China Railway Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 China Railway Group had debt of CN¥363.9b, up from CN¥283.3b in one year. However, because it has a cash reserve of CN¥196.0b, its net debt is less, at about CN¥167.9b.

How Healthy Is China Railway Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Railway Group had liabilities of CN¥854.3b due within 12 months and liabilities of CN¥281.2b due beyond that. On the other hand, it had cash of CN¥196.0b and CN¥350.8b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥588.8b.

This deficit casts a shadow over the CN¥137.2b 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, China Railway Group would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Railway Group's net debt is 3.1 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 29.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. If China Railway Group can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Railway Group 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 always check how much of that EBIT is translated into free cash flow. During the last three years, China Railway Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, China Railway Group's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider China Railway Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 2 warning signs for China Railway Group (1 is concerning) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.