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.' 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 Grace Fabric Technology Co.,Ltd. (SHSE:603256) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Grace Fabric TechnologyLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Grace Fabric TechnologyLtd had CN¥936.1m of debt, an increase on CN¥869.7m, over one year. On the flip side, it has CN¥293.5m in cash leading to net debt of about CN¥642.6m.

How Strong Is Grace Fabric TechnologyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Grace Fabric TechnologyLtd had liabilities of CN¥606.2m due within 12 months and liabilities of CN¥524.9m due beyond that. On the other hand, it had cash of CN¥293.5m and CN¥432.0m worth of receivables due within a year. So it has liabilities totalling CN¥405.5m more than its cash and near-term receivables, combined.

Of course, Grace Fabric TechnologyLtd has a market capitalization of CN¥7.79b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.097 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in Grace Fabric TechnologyLtd like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Grace Fabric TechnologyLtd is that it turned last year's EBIT loss into a gain of CN¥3.1m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Grace Fabric TechnologyLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Grace Fabric TechnologyLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We weren't impressed with Grace Fabric TechnologyLtd's net debt to EBITDA, and its interest cover made us cautious. But its conversion of EBIT to free cash flow was significantly redeeming. When we consider all the elements mentioned above, it seems to us that Grace Fabric TechnologyLtd is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Grace Fabric TechnologyLtd that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.