Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Eternal Asia Supply Chain Management Ltd. (SZSE:002183) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Eternal Asia Supply Chain Management's Debt?

You can click the graphic below for the historical numbers, but it shows that Eternal Asia Supply Chain Management had CN¥22.9b of debt in March 2024, down from CN¥24.0b, one year before. However, it does have CN¥10.3b in cash offsetting this, leading to net debt of about CN¥12.7b.

A Look At Eternal Asia Supply Chain Management's Liabilities

Zooming in on the latest balance sheet data, we can see that Eternal Asia Supply Chain Management had liabilities of CN¥37.6b due within 12 months and liabilities of CN¥3.15b due beyond that. Offsetting these obligations, it had cash of CN¥10.3b as well as receivables valued at CN¥18.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥11.9b.

Given this deficit is actually higher than the company's market capitalization of CN¥9.38b, we think shareholders really should watch Eternal Asia Supply Chain Management's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 10.1 hit our confidence in Eternal Asia Supply Chain Management like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Eternal Asia Supply Chain Management saw its EBIT drop by 11% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Eternal Asia Supply Chain Management will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Considering the last three years, Eternal Asia Supply Chain Management actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Eternal Asia Supply Chain Management's interest cover and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. And even its level of total liabilities fails to inspire much confidence. After considering the datapoints discussed, we think Eternal Asia Supply Chain Management has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 3 warning signs for Eternal Asia Supply Chain Management (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.