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. As with many other companies Changzhou Tenglong AutoPartsCo.,Ltd. (SHSE:603158) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Changzhou Tenglong AutoPartsCo.Ltd

How Much Debt Does Changzhou Tenglong AutoPartsCo.Ltd Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Changzhou Tenglong AutoPartsCo.Ltd had debt of CN¥907.4m, up from CN¥800.9m in one year. On the flip side, it has CN¥508.1m in cash leading to net debt of about CN¥399.3m.

How Healthy Is Changzhou Tenglong AutoPartsCo.Ltd's Balance Sheet?

The latest balance sheet data shows that Changzhou Tenglong AutoPartsCo.Ltd had liabilities of CN¥1.84b due within a year, and liabilities of CN¥150.4m falling due after that. On the other hand, it had cash of CN¥508.1m and CN¥1.12b worth of receivables due within a year. So it has liabilities totalling CN¥361.0m more than its cash and near-term receivables, combined.

Given Changzhou Tenglong AutoPartsCo.Ltd has a market capitalization of CN¥4.25b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Changzhou Tenglong AutoPartsCo.Ltd has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.3 times the interest expense over the last year. On top of that, Changzhou Tenglong AutoPartsCo.Ltd grew its EBIT by 58% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Changzhou Tenglong AutoPartsCo.Ltd'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. Over the last three years, Changzhou Tenglong AutoPartsCo.Ltd recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

When it comes to the balance sheet, the standout positive for Changzhou Tenglong AutoPartsCo.Ltd was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that Changzhou Tenglong AutoPartsCo.Ltd is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 2 warning signs we've spotted with Changzhou Tenglong AutoPartsCo.Ltd (including 1 which is concerning) .

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.