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.' 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. We can see that Jiangsu Eastern Shenghong Co.,Ltd. (SZSE:000301) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Jiangsu Eastern ShenghongLtd's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Jiangsu Eastern ShenghongLtd had debt of CN¥138.6b, up from CN¥112.5b in one year. On the flip side, it has CN¥10.7b in cash leading to net debt of about CN¥127.9b.

A Look At Jiangsu Eastern ShenghongLtd's Liabilities

The latest balance sheet data shows that Jiangsu Eastern ShenghongLtd had liabilities of CN¥86.2b due within a year, and liabilities of CN¥81.0b falling due after that. Offsetting this, it had CN¥10.7b in cash and CN¥5.53b in receivables that were due within 12 months. So its liabilities total CN¥151.0b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥56.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Jiangsu Eastern ShenghongLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Jiangsu Eastern ShenghongLtd shareholders face the double whammy of a high net debt to EBITDA ratio (14.6), and fairly weak interest coverage, since EBIT is just 0.49 times the interest expense. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Jiangsu Eastern ShenghongLtd saw its EBIT drop by 11% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Jiangsu Eastern ShenghongLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Jiangsu Eastern ShenghongLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Jiangsu Eastern ShenghongLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. It looks to us like Jiangsu Eastern ShenghongLtd carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. Case in point: We've spotted 2 warning signs for Jiangsu Eastern ShenghongLtd you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.