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.' 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 can see that Guizhou Wire Rope Incorporated Company (SHSE:600992) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for Guizhou Wire Rope
How Much Debt Does Guizhou Wire Rope Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2022 Guizhou Wire Rope had CN¥938.7m of debt, an increase on CN¥900.8m, over one year. However, it also had CN¥452.0m in cash, and so its net debt is CN¥486.7m.
A Look At Guizhou Wire Rope's Liabilities
The latest balance sheet data shows that Guizhou Wire Rope had liabilities of CN¥1.43b due within a year, and liabilities of CN¥408.7m falling due after that. Offsetting this, it had CN¥452.0m in cash and CN¥482.1m in receivables that were due within 12 months. So its liabilities total CN¥902.2m more than the combination of its cash and short-term receivables.
Of course, Guizhou Wire Rope has a market capitalization of CN¥6.39b, so these liabilities are probably manageable. 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.
Strangely Guizhou Wire Rope has a sky high EBITDA ratio of 13.1, implying high debt, but a strong interest coverage of 223. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Guizhou Wire Rope's EBIT was down 77% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Guizhou Wire Rope's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Guizhou Wire Rope saw substantial negative free cash flow, in total. 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
To be frank both Guizhou Wire Rope's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that Guizhou Wire Rope has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. To that end, you should learn about the 3 warning signs we've spotted with Guizhou Wire Rope (including 1 which doesn't sit too well with us) .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.