The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Guizhou Aviation Technical Development Co., Ltd (SHSE:688239) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Guizhou Aviation Technical Development's Net Debt?

As you can see below, Guizhou Aviation Technical Development had CN¥768.3m of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥256.9m in cash leading to net debt of about CN¥511.4m.

How Strong Is Guizhou Aviation Technical Development's Balance Sheet?

According to the last reported balance sheet, Guizhou Aviation Technical Development had liabilities of CN¥1.18b due within 12 months, and liabilities of CN¥507.6m due beyond 12 months. On the other hand, it had cash of CN¥256.9m and CN¥1.25b worth of receivables due within a year. So its liabilities total CN¥181.3m more than the combination of its cash and short-term receivables.

Of course, Guizhou Aviation Technical Development has a market capitalization of CN¥4.96b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Guizhou Aviation Technical Development's net debt of 1.8 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.3 times its interest expenses harmonizes with that theme. Importantly Guizhou Aviation Technical Development's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guizhou Aviation Technical Development can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Guizhou Aviation Technical Development saw substantial negative free cash flow, in total. 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

Guizhou Aviation Technical Development'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 interest cover was re-invigorating. We think that Guizhou Aviation Technical Development's debt does make it a bit risky, after considering the aforementioned data points together. 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. However, not all investment risk resides within the balance sheet - far from it. For example - Guizhou Aviation Technical Development has 1 warning sign we think you should be aware of.

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.

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