Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Qingdao Tianneng Heavy Industries Co.,Ltd (SZSE:300569) does carry 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. 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.

Check out our latest analysis for Qingdao Tianneng Heavy IndustriesLtd

What Is Qingdao Tianneng Heavy IndustriesLtd's Debt?

The image below, which you can click on for greater detail, shows that Qingdao Tianneng Heavy IndustriesLtd had debt of CN¥3.35b at the end of September 2023, a reduction from CN¥3.61b over a year. On the flip side, it has CN¥1.32b in cash leading to net debt of about CN¥2.03b.

How Strong Is Qingdao Tianneng Heavy IndustriesLtd's Balance Sheet?

According to the last reported balance sheet, Qingdao Tianneng Heavy IndustriesLtd had liabilities of CN¥3.88b due within 12 months, and liabilities of CN¥3.33b due beyond 12 months. Offsetting this, it had CN¥1.32b in cash and CN¥3.66b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.24b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Qingdao Tianneng Heavy IndustriesLtd is worth CN¥5.11b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Qingdao Tianneng Heavy IndustriesLtd's net debt is 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 10.6 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Qingdao Tianneng Heavy IndustriesLtd grew its EBIT by 7.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Qingdao Tianneng Heavy IndustriesLtd'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Qingdao Tianneng Heavy IndustriesLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Qingdao Tianneng Heavy IndustriesLtd's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its interest cover was refreshing. Taking the abovementioned factors together we do think Qingdao Tianneng Heavy IndustriesLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Qingdao Tianneng Heavy IndustriesLtd is showing 2 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.