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 Jiangsu Eastern Shenghong Co.,Ltd. (SZSE:000301) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Jiangsu Eastern ShenghongLtd's Debt?

As you can see below, at the end of March 2024, Jiangsu Eastern ShenghongLtd had CN¥135.2b of debt, up from CN¥112.0b a year ago. Click the image for more detail. However, it does have CN¥12.1b in cash offsetting this, leading to net debt of about CN¥123.2b.

A Look At Jiangsu Eastern ShenghongLtd's Liabilities

According to the last reported balance sheet, Jiangsu Eastern ShenghongLtd had liabilities of CN¥84.5b due within 12 months, and liabilities of CN¥81.3b due beyond 12 months. Offsetting these obligations, it had cash of CN¥12.1b as well as receivables valued at CN¥3.75b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥150.0b.

The deficiency here weighs heavily on the CN¥53.0b 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'd watch its balance sheet closely, without a doubt. At the end of the day, Jiangsu Eastern ShenghongLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 0.79 times and a disturbingly high net debt to EBITDA ratio of 14.6 hit our confidence in Jiangsu Eastern ShenghongLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a lighter note, we note that Jiangsu Eastern ShenghongLtd grew its EBIT by 23% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Jiangsu Eastern ShenghongLtd'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.

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, Jiangsu Eastern ShenghongLtd 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, Jiangsu Eastern ShenghongLtd'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 at least it's pretty decent at growing its EBIT; that's encouraging. Taking into account all the aforementioned factors, it looks like Jiangsu Eastern ShenghongLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 4 warning signs for Jiangsu Eastern ShenghongLtd you should be aware of, and 2 of them shouldn't be ignored.

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.

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