Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Guangxi Liugong Machinery Co., Ltd. (SZSE:000528) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Guangxi Liugong Machinery's Debt?

The image below, which you can click on for greater detail, shows that Guangxi Liugong Machinery had debt of CN¥10.8b at the end of March 2024, a reduction from CN¥12.7b over a year. On the flip side, it has CN¥8.86b in cash leading to net debt of about CN¥1.94b.

How Strong Is Guangxi Liugong Machinery's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangxi Liugong Machinery had liabilities of CN¥22.2b due within 12 months and liabilities of CN¥6.13b due beyond that. Offsetting these obligations, it had cash of CN¥8.86b as well as receivables valued at CN¥12.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.28b.

While this might seem like a lot, it is not so bad since Guangxi Liugong Machinery has a market capitalization of CN¥18.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Guangxi Liugong Machinery's net debt is only 0.87 times its EBITDA. And its EBIT covers its interest expense a whopping 89.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Guangxi Liugong Machinery grew its EBIT by 64% over the last twelve months, and that growth will make it easier to handle its debt. 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 Guangxi Liugong Machinery'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Guangxi Liugong Machinery created free cash flow amounting to 19% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

The good news is that Guangxi Liugong Machinery's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Guangxi Liugong Machinery can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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 - Guangxi Liugong Machinery has 2 warning signs we think you should be aware of.

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.

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.