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.' 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. Importantly, Yinbang Clad Material Co.,Ltd (SZSE:300337) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Yinbang Clad MaterialLtd's Net Debt?

As you can see below, at the end of June 2024, Yinbang Clad MaterialLtd had CN¥2.64b of debt, up from CN¥2.42b a year ago. Click the image for more detail. However, it does have CN¥370.8m in cash offsetting this, leading to net debt of about CN¥2.27b.

A Look At Yinbang Clad MaterialLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Yinbang Clad MaterialLtd had liabilities of CN¥1.17b due within 12 months and liabilities of CN¥2.21b due beyond that. Offsetting these obligations, it had cash of CN¥370.8m as well as receivables valued at CN¥1.16b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.85b.

While this might seem like a lot, it is not so bad since Yinbang Clad MaterialLtd has a market capitalization of CN¥6.08b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 7.3 hit our confidence in Yinbang Clad MaterialLtd like a one-two punch to the gut. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Yinbang Clad MaterialLtd actually grew its EBIT by a hefty 124%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Yinbang Clad MaterialLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Yinbang Clad MaterialLtd saw substantial negative free cash flow, in total. 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

Neither Yinbang Clad MaterialLtd's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Yinbang Clad MaterialLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Yinbang Clad MaterialLtd has 3 warning signs we think you should be aware of.

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.