Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Greattown Holdings Ltd. (SHSE:900940) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Greattown Holdings

What Is Greattown Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that Greattown Holdings had debt of CN¥5.03b at the end of June 2023, a reduction from CN¥8.46b over a year. However, it also had CN¥3.66b in cash, and so its net debt is CN¥1.37b.

How Healthy Is Greattown Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Greattown Holdings had liabilities of CN¥17.4b due within 12 months and liabilities of CN¥2.22b due beyond that. Offsetting this, it had CN¥3.66b in cash and CN¥616.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥15.3b.

The deficiency here weighs heavily on the CN¥7.66b 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, Greattown Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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

Greattown Holdings has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 14.0 times over. So we're pretty relaxed about its super-conservative use of debt. It was also good to see that despite losing money on the EBIT line last year, Greattown Holdings turned things around in the last 12 months, delivering and EBIT of CN¥1.0b. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Greattown Holdings 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Greattown Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We feel some trepidation about Greattown Holdings's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. We think that Greattown Holdings's debt does make it a bit risky, after considering the aforementioned data points together. 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 1 warning sign with Greattown Holdings , and understanding them should be part of your investment process.

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.