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.' 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. As with many other companies Yueyang Forest & Paper Co., Ltd. (SHSE:600963) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Yueyang Forest & Paper's Net Debt?

As you can see below, at the end of September 2024, Yueyang Forest & Paper had CN¥6.16b of debt, up from CN¥4.78b a year ago. Click the image for more detail. On the flip side, it has CN¥909.0m in cash leading to net debt of about CN¥5.25b.

How Healthy Is Yueyang Forest & Paper's Balance Sheet?

The latest balance sheet data shows that Yueyang Forest & Paper had liabilities of CN¥5.55b due within a year, and liabilities of CN¥3.13b falling due after that. On the other hand, it had cash of CN¥909.0m and CN¥3.03b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.74b.

While this might seem like a lot, it is not so bad since Yueyang Forest & Paper has a market capitalization of CN¥10.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. 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 Yueyang Forest & Paper'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.

Over 12 months, Yueyang Forest & Paper made a loss at the EBIT level, and saw its revenue drop to CN¥7.2b, which is a fall of 28%. To be frank that doesn't bode well.

Caveat Emptor

While Yueyang Forest & Paper's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at CN¥17m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥377m in negative free cash flow over the last twelve months. So to be blunt we think it is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Yueyang Forest & Paper has 1 warning sign we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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