Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Guangxi Guiguan Electric PowerCo.,Ltd. (SHSE:600236) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Guangxi Guiguan Electric PowerCo.Ltd's Debt?

As you can see below, at the end of March 2024, Guangxi Guiguan Electric PowerCo.Ltd had CN¥23.4b of debt, up from CN¥19.5b a year ago. Click the image for more detail. However, it does have CN¥1.89b in cash offsetting this, leading to net debt of about CN¥21.5b.

How Strong Is Guangxi Guiguan Electric PowerCo.Ltd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangxi Guiguan Electric PowerCo.Ltd had liabilities of CN¥16.0b due within 12 months and liabilities of CN¥10.7b due beyond that. Offsetting this, it had CN¥1.89b in cash and CN¥1.97b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥22.9b.

Guangxi Guiguan Electric PowerCo.Ltd has a market capitalization of CN¥60.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Guangxi Guiguan Electric PowerCo.Ltd has a rather high debt to EBITDA ratio of 5.0 which suggests a meaningful debt load. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Shareholders should be aware that Guangxi Guiguan Electric PowerCo.Ltd's EBIT was down 49% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Guangxi Guiguan Electric PowerCo.Ltd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Guangxi Guiguan Electric PowerCo.Ltd produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Guangxi Guiguan Electric PowerCo.Ltd's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Guangxi Guiguan Electric PowerCo.Ltd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Guangxi Guiguan Electric PowerCo.Ltd (2 shouldn't be ignored) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com