David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Gaona Aero Material Co., Ltd. (SZSE:300034) does have debt on its balance sheet. 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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Gaona Aero Material's Net Debt?

As you can see below, Gaona Aero Material had CN¥727.3m of debt at September 2023, down from CN¥761.5m a year prior. However, it does have CN¥613.6m in cash offsetting this, leading to net debt of about CN¥113.8m.

A Look At Gaona Aero Material's Liabilities

We can see from the most recent balance sheet that Gaona Aero Material had liabilities of CN¥2.86b falling due within a year, and liabilities of CN¥633.8m due beyond that. On the other hand, it had cash of CN¥613.6m and CN¥2.65b worth of receivables due within a year. So its liabilities total CN¥232.3m more than the combination of its cash and short-term receivables.

Having regard to Gaona Aero Material's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥12.1b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Gaona Aero Material has a very light debt load indeed.

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

Gaona Aero Material has a low net debt to EBITDA ratio of only 0.20. And its EBIT easily covers its interest expense, being 28.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Gaona Aero Material has boosted its EBIT by 58%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gaona Aero Material 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Gaona Aero Material 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

Happily, Gaona Aero Material's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Gaona Aero Material is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Gaona Aero Material .

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.