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.' 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 note that GRG Metrology & Test Group Co., Ltd. (SZSE:002967) 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 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is GRG Metrology & Test Group's Debt?

As you can see below, at the end of June 2024, GRG Metrology & Test Group had CN¥1.49b of debt, up from CN¥1.21b a year ago. Click the image for more detail. However, it does have CN¥1.03b in cash offsetting this, leading to net debt of about CN¥455.9m.

How Strong Is GRG Metrology & Test Group's Balance Sheet?

The latest balance sheet data shows that GRG Metrology & Test Group had liabilities of CN¥1.64b due within a year, and liabilities of CN¥934.2m falling due after that. Offsetting these obligations, it had cash of CN¥1.03b as well as receivables valued at CN¥1.82b due within 12 months. So it can boast CN¥280.4m more liquid assets than total liabilities.

This surplus suggests that GRG Metrology & Test Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

GRG Metrology & Test Group's net debt is only 0.90 times its EBITDA. And its EBIT easily covers its interest expense, being 21.0 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, GRG Metrology & Test Group grew its EBIT by 37% over the last twelve months, and that growth will make it easier to handle its 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 GRG Metrology & Test Group can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, GRG Metrology & Test Group burned a lot of cash. 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

Happily, GRG Metrology & Test Group's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like GRG Metrology & Test Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. To that end, you should be aware of the 1 warning sign we've spotted with GRG Metrology & Test Group .

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.