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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Shandong Homey Aquatic Development Co.,Ltd. (SHSE:600467) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shandong Homey Aquatic DevelopmentLtd's Net Debt?

The chart below, which you can click on for greater detail, shows that Shandong Homey Aquatic DevelopmentLtd had CN¥2.52b in debt in September 2024; about the same as the year before. However, it also had CN¥399.7m in cash, and so its net debt is CN¥2.12b.

A Look At Shandong Homey Aquatic DevelopmentLtd's Liabilities

We can see from the most recent balance sheet that Shandong Homey Aquatic DevelopmentLtd had liabilities of CN¥2.80b falling due within a year, and liabilities of CN¥688.6m due beyond that. On the other hand, it had cash of CN¥399.7m and CN¥31.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.06b.

This is a mountain of leverage relative to its market capitalization of CN¥4.25b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Weak interest cover of 1.0 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in Shandong Homey Aquatic DevelopmentLtd like a one-two punch to the gut. The debt burden here is substantial. Worse, Shandong Homey Aquatic DevelopmentLtd's EBIT was down 36% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Homey Aquatic DevelopmentLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Shandong Homey Aquatic DevelopmentLtd produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Shandong Homey Aquatic DevelopmentLtd's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Shandong Homey Aquatic DevelopmentLtd 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. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Shandong Homey Aquatic DevelopmentLtd (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.