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. Importantly, GD Power Development Co.,Ltd (SHSE:600795) does carry debt. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does GD Power DevelopmentLtd Carry?
The image below, which you can click on for greater detail, shows that at September 2023 GD Power DevelopmentLtd had debt of CN¥262.9b, up from CN¥227.5b in one year. However, because it has a cash reserve of CN¥25.3b, its net debt is less, at about CN¥237.6b.
How Healthy Is GD Power DevelopmentLtd's Balance Sheet?
According to the last reported balance sheet, GD Power DevelopmentLtd had liabilities of CN¥134.5b due within 12 months, and liabilities of CN¥187.5b due beyond 12 months. Offsetting these obligations, it had cash of CN¥25.3b as well as receivables valued at CN¥25.6b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥271.1b.
The deficiency here weighs heavily on the CN¥91.7b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, GD Power DevelopmentLtd would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
GD Power DevelopmentLtd has a rather high debt to EBITDA ratio of 5.9 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.6 times, suggesting it can responsibly service its obligations. The good news is that GD Power DevelopmentLtd grew its EBIT a smooth 36% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine GD Power DevelopmentLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, GD Power DevelopmentLtd created free cash flow amounting to 18% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
On the face of it, GD Power DevelopmentLtd's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that GD Power DevelopmentLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example GD Power DevelopmentLtd has 3 warning signs (and 1 which is concerning) we think you should know about.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.