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 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 GCL Energy Technology Co.,Ltd. (SZSE:002015) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is GCL Energy TechnologyLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 GCL Energy TechnologyLtd had debt of CN¥11.9b, up from CN¥9.13b in one year. However, it does have CN¥3.64b in cash offsetting this, leading to net debt of about CN¥8.29b.

A Look At GCL Energy TechnologyLtd's Liabilities

The latest balance sheet data shows that GCL Energy TechnologyLtd had liabilities of CN¥12.4b due within a year, and liabilities of CN¥13.1b falling due after that. Offsetting these obligations, it had cash of CN¥3.64b as well as receivables valued at CN¥5.57b due within 12 months. So it has liabilities totalling CN¥16.3b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥13.4b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt to EBITDA of 4.3 GCL Energy TechnologyLtd has a fairly noticeable amount of debt. On the plus side, its EBIT was 9.5 times its interest expense, and its net debt to EBITDA, was quite high, at 4.3. Unfortunately, GCL Energy TechnologyLtd saw its EBIT slide 3.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine GCL Energy TechnologyLtd'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, GCL Energy TechnologyLtd 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

Mulling over GCL Energy TechnologyLtd's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider GCL Energy TechnologyLtd to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Be aware that GCL Energy TechnologyLtd is showing 3 warning signs in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.