Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that FULONGMA GROUP Co.,Ltd. (SHSE:603686) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is FULONGMA GROUPLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 FULONGMA GROUPLtd had CN¥832.6m of debt, an increase on CN¥287.4m, over one year. However, it also had CN¥762.4m in cash, and so its net debt is CN¥70.2m.

How Strong Is FULONGMA GROUPLtd's Balance Sheet?

We can see from the most recent balance sheet that FULONGMA GROUPLtd had liabilities of CN¥2.46b falling due within a year, and liabilities of CN¥555.7m due beyond that. Offsetting this, it had CN¥762.4m in cash and CN¥3.53b in receivables that were due within 12 months. So it can boast CN¥1.27b more liquid assets than total liabilities.

This surplus suggests that FULONGMA GROUPLtd is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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

FULONGMA GROUPLtd has a low net debt to EBITDA ratio of only 0.14. And its EBIT easily covers its interest expense, being 162 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that FULONGMA GROUPLtd's load is not too heavy, because its EBIT was down 27% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 FULONGMA GROUPLtd 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, FULONGMA GROUPLtd recorded negative free cash flow, in total. 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

FULONGMA GROUPLtd's EBIT growth rate was a real negative on this analysis, as was its conversion of EBIT to free cash flow. But like a ballerina ending on a perfect pirouette, it has not trouble covering its interest expense with its EBIT. When we consider all the elements mentioned above, it seems to us that FULONGMA GROUPLtd is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that FULONGMA GROUPLtd is showing 2 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.