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 Shaanxi Jinye Science Technology and Education Group Co.,Ltd (SZSE:000812) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shaanxi Jinye Science Technology and Education GroupLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shaanxi Jinye Science Technology and Education GroupLtd had debt of CN¥1.59b, up from CN¥1.23b in one year. On the flip side, it has CN¥303.2m in cash leading to net debt of about CN¥1.29b.

How Healthy Is Shaanxi Jinye Science Technology and Education GroupLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shaanxi Jinye Science Technology and Education GroupLtd had liabilities of CN¥2.56b due within 12 months and liabilities of CN¥863.3m due beyond that. On the other hand, it had cash of CN¥303.2m and CN¥416.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.70b.

This is a mountain of leverage relative to its market capitalization of CN¥4.18b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Shaanxi Jinye Science Technology and Education GroupLtd's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 2.5, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. On the other hand, Shaanxi Jinye Science Technology and Education GroupLtd grew its EBIT by 23% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shaanxi Jinye Science Technology and Education GroupLtd 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.

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, Shaanxi Jinye Science Technology and Education GroupLtd 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

Mulling over Shaanxi Jinye Science Technology and Education GroupLtd's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Shaanxi Jinye Science Technology and Education GroupLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 1 warning sign with Shaanxi Jinye Science Technology and Education GroupLtd , and understanding them should be part of your investment process.

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.