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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Tianshan Material Co., Ltd. (SZSE:000877) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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 Tianshan Material's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Tianshan Material had debt of CN¥151.3b, up from CN¥141.8b in one year. However, because it has a cash reserve of CN¥18.4b, its net debt is less, at about CN¥132.9b.

How Strong Is Tianshan Material's Balance Sheet?

The latest balance sheet data shows that Tianshan Material had liabilities of CN¥111.6b due within a year, and liabilities of CN¥89.3b falling due after that. Offsetting these obligations, it had cash of CN¥18.4b as well as receivables valued at CN¥38.6b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥143.9b.

This deficit casts a shadow over the CN¥44.3b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Tianshan Material would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 9.7 hit our confidence in Tianshan Material like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Tianshan Material's EBIT was down 25% 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tianshan Material can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Tianshan Material recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Tianshan Material's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. Considering all the factors previously mentioned, we think that Tianshan Material really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Tianshan Material has 4 warning signs (and 1 which is potentially serious) we think you should know about.

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.

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