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 Guangdong Feinan Resources Recycling Co., Ltd (SZSE:301500) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Guangdong Feinan Resources Recycling's Debt?

As you can see below, at the end of March 2024, Guangdong Feinan Resources Recycling had CN¥4.68b of debt, up from CN¥2.84b a year ago. Click the image for more detail. On the flip side, it has CN¥450.7m in cash leading to net debt of about CN¥4.23b.

How Strong Is Guangdong Feinan Resources Recycling's Balance Sheet?

According to the last reported balance sheet, Guangdong Feinan Resources Recycling had liabilities of CN¥4.42b due within 12 months, and liabilities of CN¥2.25b due beyond 12 months. On the other hand, it had cash of CN¥450.7m and CN¥243.6m worth of receivables due within a year. So its liabilities total CN¥5.98b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥7.68b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Guangdong Feinan Resources Recycling shareholders face the double whammy of a high net debt to EBITDA ratio (13.3), and fairly weak interest coverage, since EBIT is just 0.97 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Guangdong Feinan Resources Recycling's EBIT was down 68% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Guangdong Feinan Resources Recycling 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Guangdong Feinan Resources Recycling saw substantial negative free cash flow, in total. 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, Guangdong Feinan Resources Recycling's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Guangdong Feinan Resources Recycling has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Guangdong Feinan Resources Recycling (of which 4 can't be ignored!) you should know about.

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.