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. As with many other companies Guangzhou Guanggang Gases & Energy Co.,Ltd. (SHSE:688548) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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.
How Much Debt Does Guangzhou Guanggang Gases & EnergyLtd Carry?
You can click the graphic below for the historical numbers, but it shows that Guangzhou Guanggang Gases & EnergyLtd had CN¥764.7m of debt in March 2024, down from CN¥809.1m, one year before. However, it does have CN¥472.0m in cash offsetting this, leading to net debt of about CN¥292.6m.
How Healthy Is Guangzhou Guanggang Gases & EnergyLtd's Balance Sheet?
The latest balance sheet data shows that Guangzhou Guanggang Gases & EnergyLtd had liabilities of CN¥873.4m due within a year, and liabilities of CN¥723.4m falling due after that. On the other hand, it had cash of CN¥472.0m and CN¥415.4m worth of receivables due within a year. So it has liabilities totalling CN¥709.4m more than its cash and near-term receivables, combined.
Since publicly traded Guangzhou Guanggang Gases & EnergyLtd shares are worth a total of CN¥13.4b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Guangzhou Guanggang Gases & EnergyLtd has a low debt to EBITDA ratio of only 0.57. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. The modesty of its debt load may become crucial for Guangzhou Guanggang Gases & EnergyLtd if management cannot prevent a repeat of the 20% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guangzhou Guanggang Gases & EnergyLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Guangzhou Guanggang Gases & EnergyLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Neither Guangzhou Guanggang Gases & EnergyLtd's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Guangzhou Guanggang Gases & EnergyLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Case in point: We've spotted 2 warning signs for Guangzhou Guanggang Gases & EnergyLtd you should be aware of, and 1 of them is significant.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.