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 Henan Zhongyuan Expressway Company Limited (SHSE:600020) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Henan Zhongyuan Expressway

What Is Henan Zhongyuan Expressway's Net Debt?

The chart below, which you can click on for greater detail, shows that Henan Zhongyuan Expressway had CN¥31.5b in debt in September 2023; about the same as the year before. However, because it has a cash reserve of CN¥921.6m, its net debt is less, at about CN¥30.6b.

A Look At Henan Zhongyuan Expressway's Liabilities

Zooming in on the latest balance sheet data, we can see that Henan Zhongyuan Expressway had liabilities of CN¥7.17b due within 12 months and liabilities of CN¥27.8b due beyond that. Offsetting these obligations, it had cash of CN¥921.6m as well as receivables valued at CN¥817.1m due within 12 months. So its liabilities total CN¥33.2b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥8.52b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Henan Zhongyuan Expressway would probably need a major re-capitalization if its creditors were to demand repayment.

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 1.9 times and a disturbingly high net debt to EBITDA ratio of 12.1 hit our confidence in Henan Zhongyuan Expressway like a one-two punch to the gut. The debt burden here is substantial. On a lighter note, we note that Henan Zhongyuan Expressway grew its EBIT by 25% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Henan Zhongyuan Expressway 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Henan Zhongyuan Expressway recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Henan Zhongyuan Expressway's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like Henan Zhongyuan Expressway commonly do use debt without problems. Overall, we think it's fair to say that Henan Zhongyuan Expressway has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Case in point: We've spotted 2 warning signs for Henan Zhongyuan Expressway you should be aware of.

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.