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.' 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 Henan Yuguang Gold&Lead Co.,Ltd. (SHSE:600531) 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 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 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Henan Yuguang Gold&LeadLtd Carry?

As you can see below, at the end of September 2023, Henan Yuguang Gold&LeadLtd had CN¥8.15b of debt, up from CN¥7.52b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.89b, its net debt is less, at about CN¥6.26b.

How Healthy Is Henan Yuguang Gold&LeadLtd's Balance Sheet?

According to the last reported balance sheet, Henan Yuguang Gold&LeadLtd had liabilities of CN¥8.49b due within 12 months, and liabilities of CN¥2.33b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.89b as well as receivables valued at CN¥647.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.28b.

When you consider that this deficiency exceeds the company's CN¥5.93b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

As it happens Henan Yuguang Gold&LeadLtd has a fairly concerning net debt to EBITDA ratio of 6.0 but very strong interest coverage of 143. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably, Henan Yuguang Gold&LeadLtd's EBIT launched higher than Elon Musk, gaining a whopping 829% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Henan Yuguang Gold&LeadLtd'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Henan Yuguang Gold&LeadLtd recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Henan Yuguang Gold&LeadLtd's level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that Henan Yuguang Gold&LeadLtd has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example, we've discovered 2 warning signs for Henan Yuguang Gold&LeadLtd (1 is a bit unpleasant!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.