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.' 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 note that Xiangtan Electric Manufacturing Co. Ltd. (SHSE:600416) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Xiangtan Electric Manufacturing Carry?

As you can see below, at the end of March 2024, Xiangtan Electric Manufacturing had CN¥2.61b of debt, up from CN¥2.22b a year ago. Click the image for more detail. However, it does have CN¥2.14b in cash offsetting this, leading to net debt of about CN¥468.4m.

How Strong Is Xiangtan Electric Manufacturing's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Xiangtan Electric Manufacturing had liabilities of CN¥5.88b due within 12 months and liabilities of CN¥1.13b due beyond that. Offsetting these obligations, it had cash of CN¥2.14b as well as receivables valued at CN¥4.88b due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to Xiangtan Electric Manufacturing's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥13.4b company is short on cash, but still worth keeping an eye on the balance sheet.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt sitting at just 1.0 times EBITDA, Xiangtan Electric Manufacturing is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.9 times the interest expense over the last year. In fact Xiangtan Electric Manufacturing's saving grace is its low debt levels, because its EBIT has tanked 43% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Xiangtan Electric Manufacturing's earnings that will influence how the balance sheet holds up in the future. 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.

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. During the last three years, Xiangtan Electric Manufacturing 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

While Xiangtan Electric Manufacturing's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But at least its interest cover is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Xiangtan Electric Manufacturing's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in Xiangtan Electric Manufacturing, you may well want to click here to check an interactive graph of its earnings per share history.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.