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.' 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 China Railway Construction Corporation Limited (SHSE:601186) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is China Railway Construction's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 China Railway Construction had CN¥393.8b of debt, an increase on CN¥314.2b, over one year. However, it does have CN¥150.8b in cash offsetting this, leading to net debt of about CN¥243.0b.

How Strong Is China Railway Construction's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Railway Construction had liabilities of CN¥1.03t due within 12 months and liabilities of CN¥258.0b due beyond that. Offsetting these obligations, it had cash of CN¥150.8b as well as receivables valued at CN¥548.0b due within 12 months. So it has liabilities totalling CN¥592.8b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥111.2b 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 definitely think shareholders need to watch this one closely. After all, China Railway Construction would likely require a major re-capitalisation if it had to pay its creditors today.

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

China Railway Construction has a debt to EBITDA ratio of 3.7, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 12.5 is very high, suggesting that the interest expense on the debt is currently quite low. Notably China Railway Construction's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. 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 China Railway Construction can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, China Railway Construction burned a lot of cash. 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, China Railway Construction's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities 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. Overall, it seems to us that China Railway Construction's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for China Railway Construction you should be aware of, and 1 of them is a bit unpleasant.

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.