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. We can see that Jiangsu Tongrun Equipment Technology Co.,Ltd (SZSE:002150) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Jiangsu Tongrun Equipment TechnologyLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Jiangsu Tongrun Equipment TechnologyLtd had CN¥1.03b of debt, an increase on CN¥41.0m, over one year. However, it does have CN¥892.2m in cash offsetting this, leading to net debt of about CN¥139.0m.

A Look At Jiangsu Tongrun Equipment TechnologyLtd's Liabilities

The latest balance sheet data shows that Jiangsu Tongrun Equipment TechnologyLtd had liabilities of CN¥1.50b due within a year, and liabilities of CN¥728.7m falling due after that. On the other hand, it had cash of CN¥892.2m and CN¥826.7m worth of receivables due within a year. So its liabilities total CN¥505.3m more than the combination of its cash and short-term receivables.

Of course, Jiangsu Tongrun Equipment TechnologyLtd has a market capitalization of CN¥4.50b, 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 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).

Jiangsu Tongrun Equipment TechnologyLtd's net debt is only 0.62 times its EBITDA. And its EBIT easily covers its interest expense, being 14.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Jiangsu Tongrun Equipment TechnologyLtd has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Jiangsu Tongrun Equipment TechnologyLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Jiangsu Tongrun Equipment TechnologyLtd 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

Jiangsu Tongrun Equipment TechnologyLtd's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Jiangsu Tongrun Equipment TechnologyLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Jiangsu Tongrun Equipment TechnologyLtd (of which 2 are a bit unpleasant!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com