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. We note that Ginlong Technologies Co., Ltd. (SZSE:300763) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Ginlong Technologies's Net Debt?

As you can see below, at the end of September 2023, Ginlong Technologies had CN¥8.15b of debt, up from CN¥3.51b a year ago. Click the image for more detail. On the flip side, it has CN¥2.27b in cash leading to net debt of about CN¥5.88b.

How Healthy Is Ginlong Technologies' Balance Sheet?

According to the last reported balance sheet, Ginlong Technologies had liabilities of CN¥5.73b due within 12 months, and liabilities of CN¥7.25b due beyond 12 months. Offsetting this, it had CN¥2.27b in cash and CN¥1.06b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.65b.

This deficit isn't so bad because Ginlong Technologies is worth CN¥22.5b, 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).

Ginlong Technologies has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 6.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We note that Ginlong Technologies grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Ginlong Technologies'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. During the last three years, Ginlong Technologies burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Ginlong Technologies's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its EBIT growth rate was refreshing. Looking at all the angles mentioned above, it does seem to us that Ginlong Technologies 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. 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 Ginlong Technologies is showing 3 warning signs in our investment analysis , and 2 of those are concerning...

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.