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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Black Peony (Group) Co., Ltd. (SHSE:600510) does use debt in its business. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Black Peony (Group)

What Is Black Peony (Group)'s Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Black Peony (Group) had debt of CN¥11.1b, up from CN¥10.1b in one year. However, it does have CN¥3.99b in cash offsetting this, leading to net debt of about CN¥7.16b.

A Look At Black Peony (Group)'s Liabilities

Zooming in on the latest balance sheet data, we can see that Black Peony (Group) had liabilities of CN¥12.1b due within 12 months and liabilities of CN¥8.04b due beyond that. Offsetting these obligations, it had cash of CN¥3.99b as well as receivables valued at CN¥11.7b due within 12 months. So its liabilities total CN¥4.44b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥6.17b, so it does suggest shareholders should keep an eye on Black Peony (Group)'s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Black Peony (Group) has a debt to EBITDA ratio of 3.9, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Pleasingly, Black Peony (Group) is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 148% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Black Peony (Group)'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Black Peony (Group) 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

We feel some trepidation about Black Peony (Group)'s difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Black Peony (Group) 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Black Peony (Group) (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

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.