Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Bros Eastern.,Ltd (SHSE:601339) does carry debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Bros Eastern.Ltd

What Is Bros Eastern.Ltd's Debt?

The chart below, which you can click on for greater detail, shows that Bros Eastern.Ltd had CN¥5.20b in debt in March 2023; about the same as the year before. However, it also had CN¥2.30b in cash, and so its net debt is CN¥2.90b.

How Healthy Is Bros Eastern.Ltd's Balance Sheet?

The latest balance sheet data shows that Bros Eastern.Ltd had liabilities of CN¥3.64b due within a year, and liabilities of CN¥2.25b falling due after that. Offsetting this, it had CN¥2.30b in cash and CN¥486.2m in receivables that were due within 12 months. So it has liabilities totalling CN¥3.10b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Bros Eastern.Ltd is worth CN¥8.71b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Bros Eastern.Ltd's net debt is 2.5 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k 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. Shareholders should be aware that Bros Eastern.Ltd's EBIT was down 63% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Bros Eastern.Ltd 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Bros Eastern.Ltd produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Bros Eastern.Ltd's EBIT growth rate and net debt to EBITDA definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Bros Eastern.Ltd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Bros Eastern.Ltd has 1 warning sign we think you should be aware of.

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.