Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Anhui Gourgen Traffic Construction Co.,Ltd. (SHSE:603815) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Anhui Gourgen Traffic ConstructionLtd's Debt?

As you can see below, at the end of December 2023, Anhui Gourgen Traffic ConstructionLtd had CN¥1.75b of debt, up from CN¥1.35b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.24b, its net debt is less, at about CN¥504.1m.

A Look At Anhui Gourgen Traffic ConstructionLtd's Liabilities

We can see from the most recent balance sheet that Anhui Gourgen Traffic ConstructionLtd had liabilities of CN¥7.44b falling due within a year, and liabilities of CN¥1.01b due beyond that. On the other hand, it had cash of CN¥1.24b and CN¥5.91b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.30b.

While this might seem like a lot, it is not so bad since Anhui Gourgen Traffic ConstructionLtd has a market capitalization of CN¥4.11b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Anhui Gourgen Traffic ConstructionLtd has net debt of just 1.3 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.4 times the interest expense over the last year. Also good is that Anhui Gourgen Traffic ConstructionLtd grew its EBIT at 18% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Anhui Gourgen Traffic ConstructionLtd'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Anhui Gourgen Traffic ConstructionLtd burned a lot of cash. 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

Anhui Gourgen Traffic ConstructionLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. Looking at all the angles mentioned above, it does seem to us that Anhui Gourgen Traffic ConstructionLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Anhui Gourgen Traffic ConstructionLtd is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.