Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Sichuan Guangan Aaa Public Co.,Ltd (SHSE:600979) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Sichuan Guangan Aaa PublicLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Sichuan Guangan Aaa PublicLtd had debt of CN¥3.15b, up from CN¥3.00b in one year. However, because it has a cash reserve of CN¥568.0m, its net debt is less, at about CN¥2.59b.

How Healthy Is Sichuan Guangan Aaa PublicLtd's Balance Sheet?

The latest balance sheet data shows that Sichuan Guangan Aaa PublicLtd had liabilities of CN¥1.99b due within a year, and liabilities of CN¥4.58b falling due after that. Offsetting these obligations, it had cash of CN¥568.0m as well as receivables valued at CN¥773.8m due within 12 months. So its liabilities total CN¥5.22b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥5.26b, so it does suggest shareholders should keep an eye on Sichuan Guangan Aaa PublicLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Sichuan Guangan Aaa PublicLtd's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. It is well worth noting that Sichuan Guangan Aaa PublicLtd's EBIT shot up like bamboo after rain, gaining 67% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sichuan Guangan Aaa PublicLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Sichuan Guangan Aaa PublicLtd's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Sichuan Guangan Aaa PublicLtd's EBIT growth rate 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 instance it seems like it has to struggle a bit to handle its total liabilities. It's also worth noting that Sichuan Guangan Aaa PublicLtd is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Sichuan Guangan Aaa PublicLtd's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Sichuan Guangan Aaa PublicLtd that you should be aware of.

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.