Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Tianjin Troila Information Technology Co.,Ltd. (SHSE:600225) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Tianjin Troila Information TechnologyLtd

What Is Tianjin Troila Information TechnologyLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Tianjin Troila Information TechnologyLtd had CN¥2.57b of debt, an increase on CN¥2.03b, over one year. However, because it has a cash reserve of CN¥297.0m, its net debt is less, at about CN¥2.27b.

How Strong Is Tianjin Troila Information TechnologyLtd's Balance Sheet?

We can see from the most recent balance sheet that Tianjin Troila Information TechnologyLtd had liabilities of CN¥3.86b falling due within a year, and liabilities of CN¥998.5m due beyond that. Offsetting this, it had CN¥297.0m in cash and CN¥794.2m in receivables that were due within 12 months. So its liabilities total CN¥3.77b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Tianjin Troila Information TechnologyLtd has a market capitalization of CN¥11.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Strangely Tianjin Troila Information TechnologyLtd has a sky high EBITDA ratio of 15.4, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Tianjin Troila Information TechnologyLtd's EBIT was down 98% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tianjin Troila Information TechnologyLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Tianjin Troila Information TechnologyLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Tianjin Troila Information TechnologyLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Tianjin Troila Information TechnologyLtd to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Be aware that Tianjin Troila Information TechnologyLtd is showing 3 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.