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 Tsinghua Tongfang Co.,Ltd. (SHSE:600100) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Tsinghua TongfangLtd

What Is Tsinghua TongfangLtd's Net Debt?

The image below, which you can click on for greater detail, shows that Tsinghua TongfangLtd had debt of CN¥19.1b at the end of September 2023, a reduction from CN¥21.0b over a year. On the flip side, it has CN¥7.46b in cash leading to net debt of about CN¥11.7b.

How Healthy Is Tsinghua TongfangLtd's Balance Sheet?

According to the last reported balance sheet, Tsinghua TongfangLtd had liabilities of CN¥28.3b due within 12 months, and liabilities of CN¥8.35b due beyond 12 months. Offsetting these obligations, it had cash of CN¥7.46b as well as receivables valued at CN¥10.2b due within 12 months. So it has liabilities totalling CN¥19.0b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥27.5b, so it does suggest shareholders should keep an eye on Tsinghua TongfangLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Tsinghua TongfangLtd shareholders face the double whammy of a high net debt to EBITDA ratio (12.9), and fairly weak interest coverage, since EBIT is just 0.48 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Tsinghua TongfangLtd achieved a positive EBIT of CN¥422m in the last twelve months, an improvement on the prior year's loss. 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 Tsinghua TongfangLtd 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, Tsinghua TongfangLtd reported free cash flow worth 9.7% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Tsinghua TongfangLtd's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Tsinghua TongfangLtd's balance sheet is really quite a risk to the business. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Tsinghua TongfangLtd is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.