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. We can see that Transfar Zhilian Co., Ltd. (SZSE:002010) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

How Much Debt Does Transfar Zhilian Carry?

You can click the graphic below for the historical numbers, but it shows that Transfar Zhilian had CN¥15.3b of debt in March 2024, down from CN¥16.3b, one year before. However, because it has a cash reserve of CN¥4.32b, its net debt is less, at about CN¥11.0b.

How Healthy Is Transfar Zhilian's Balance Sheet?

We can see from the most recent balance sheet that Transfar Zhilian had liabilities of CN¥12.8b falling due within a year, and liabilities of CN¥9.61b due beyond that. On the other hand, it had cash of CN¥4.32b and CN¥6.32b worth of receivables due within a year. So its liabilities total CN¥11.7b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥8.97b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Transfar Zhilian has a rather high debt to EBITDA ratio of 8.3 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that Transfar Zhilian saw its EBIT drop by 11% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Transfar Zhilian's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Transfar Zhilian burned a lot of cash. 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

On the face of it, Transfar Zhilian's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And even its EBIT growth rate fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Transfar Zhilian has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Transfar Zhilian (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

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.

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