Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Aeolus Tyre Co., Ltd. (SHSE:600469) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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.

How Much Debt Does Aeolus Tyre Carry?

The image below, which you can click on for greater detail, shows that Aeolus Tyre had debt of CN¥1.15b at the end of September 2023, a reduction from CN¥1.44b over a year. But on the other hand it also has CN¥1.21b in cash, leading to a CN¥60.2m net cash position.

How Strong Is Aeolus Tyre's Balance Sheet?

We can see from the most recent balance sheet that Aeolus Tyre had liabilities of CN¥2.99b falling due within a year, and liabilities of CN¥1.01b due beyond that. Offsetting this, it had CN¥1.21b in cash and CN¥1.60b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.18b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Aeolus Tyre has a market capitalization of CN¥3.82b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Aeolus Tyre boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Aeolus Tyre made a loss at the EBIT level, last year, it was also good to see that it generated CN¥390m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Aeolus Tyre will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Aeolus Tyre may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent year, Aeolus Tyre recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

Although Aeolus Tyre's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥60.2m. The cherry on top was that in converted 69% of that EBIT to free cash flow, bringing in CN¥269m. So we are not troubled with Aeolus Tyre's debt use. 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 be aware of the 1 warning sign we've spotted with Aeolus Tyre .

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.