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. As with many other companies Spring Airlines Co., Ltd. (SHSE:601021) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 Spring Airlines's Net Debt?

The image below, which you can click on for greater detail, shows that Spring Airlines had debt of CN¥15.8b at the end of June 2024, a reduction from CN¥19.3b over a year. On the flip side, it has CN¥9.49b in cash leading to net debt of about CN¥6.28b.

How Strong Is Spring Airlines' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Spring Airlines had liabilities of CN¥8.25b due within 12 months and liabilities of CN¥17.6b due beyond that. Offsetting this, it had CN¥9.49b in cash and CN¥505.4m in receivables that were due within 12 months. So its liabilities total CN¥15.9b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Spring Airlines is worth CN¥57.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Spring Airlines has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 11.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It was also good to see that despite losing money on the EBIT line last year, Spring Airlines turned things around in the last 12 months, delivering and EBIT of CN¥3.2b. 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 Spring Airlines 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Spring Airlines reported free cash flow worth 20% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Spring Airlines's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Spring Airlines's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 1 warning sign with Spring Airlines , and understanding them should be part of your investment process.

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.