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 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 CITIC Guoan Information Industry Co., Ltd. (SZSE:000839) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is CITIC Guoan Information Industry's Debt?

As you can see below, at the end of June 2024, CITIC Guoan Information Industry had CN¥2.70b of debt, up from CN¥2.51b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥284.3m, its net debt is less, at about CN¥2.41b.

A Look At CITIC Guoan Information Industry's Liabilities

Zooming in on the latest balance sheet data, we can see that CITIC Guoan Information Industry had liabilities of CN¥2.57b due within 12 months and liabilities of CN¥2.71b due beyond that. Offsetting this, it had CN¥284.3m in cash and CN¥1.04b in receivables that were due within 12 months. So it has liabilities totalling CN¥3.95b more than its cash and near-term receivables, combined.

CITIC Guoan Information Industry has a market capitalization of CN¥11.7b, so it could very likely raise cash to ameliorate 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.

CITIC Guoan Information Industry shareholders face the double whammy of a high net debt to EBITDA ratio (19.0), and fairly weak interest coverage, since EBIT is just 0.77 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for CITIC Guoan Information Industry is that it turned last year's EBIT loss into a gain of CN¥100m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since CITIC Guoan Information Industry will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, CITIC Guoan Information Industry 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

On the face of it, CITIC Guoan Information Industry's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We're quite clear that we consider CITIC Guoan Information Industry to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for CITIC Guoan Information Industry that you should be aware of before investing here.

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.