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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Guangxi LiuYao Group Co., Ltd (SHSE:603368) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Guangxi LiuYao Group

What Is Guangxi LiuYao Group's Debt?

The image below, which you can click on for greater detail, shows that Guangxi LiuYao Group had debt of CN¥4.45b at the end of September 2023, a reduction from CN¥5.16b over a year. However, it does have CN¥3.22b in cash offsetting this, leading to net debt of about CN¥1.23b.

How Strong Is Guangxi LiuYao Group's Balance Sheet?

We can see from the most recent balance sheet that Guangxi LiuYao Group had liabilities of CN¥12.4b falling due within a year, and liabilities of CN¥1.45b due beyond that. Offsetting this, it had CN¥3.22b in cash and CN¥11.9b in receivables that were due within 12 months. So it actually has CN¥1.25b more liquid assets than total liabilities.

It's good to see that Guangxi LiuYao Group has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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). 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).

With net debt sitting at just 0.93 times EBITDA, Guangxi LiuYao Group is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.7 times the interest expense over the last year. Also good is that Guangxi LiuYao Group grew its EBIT at 16% over the last year, further increasing its ability to manage debt. 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 Guangxi LiuYao 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Guangxi LiuYao Group's free cash flow amounted to 43% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Guangxi LiuYao Group's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its level of total liabilities is also very heartening. We would also note that Healthcare industry companies like Guangxi LiuYao Group commonly do use debt without problems. Zooming out, Guangxi LiuYao Group seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Guangxi LiuYao Group is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.