Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Sany Heavy Equipment International Holdings Company Limited (HKG:631) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Sany Heavy Equipment International Holdings Carry?

As you can see below, at the end of June 2024, Sany Heavy Equipment International Holdings had CN¥9.98b of debt, up from CN¥6.63b a year ago. Click the image for more detail. However, it does have CN¥6.63b in cash offsetting this, leading to net debt of about CN¥3.35b.

How Strong Is Sany Heavy Equipment International Holdings' Balance Sheet?

We can see from the most recent balance sheet that Sany Heavy Equipment International Holdings had liabilities of CN¥17.8b falling due within a year, and liabilities of CN¥8.41b due beyond that. Offsetting this, it had CN¥6.63b in cash and CN¥11.6b in receivables that were due within 12 months. So its liabilities total CN¥7.99b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥13.2b, so it does suggest shareholders should keep an eye on Sany Heavy Equipment International Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Sany Heavy Equipment International Holdings's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. Shareholders should be aware that Sany Heavy Equipment International Holdings's EBIT was down 21% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sany Heavy Equipment International Holdings's ability to maintain a healthy balance sheet going forward. 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. Considering the last three years, Sany Heavy Equipment International Holdings actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Sany Heavy Equipment International Holdings's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that Sany Heavy Equipment International Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the 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 1 warning sign for Sany Heavy Equipment International Holdings that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.