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.' 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. We can see that Jiangsu New Energy Development Co., Ltd. (SHSE:603693) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Jiangsu New Energy Development Carry?

The image below, which you can click on for greater detail, shows that Jiangsu New Energy Development had debt of CN¥5.35b at the end of March 2024, a reduction from CN¥7.25b over a year. However, it also had CN¥1.49b in cash, and so its net debt is CN¥3.86b.

How Healthy Is Jiangsu New Energy Development's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu New Energy Development had liabilities of CN¥2.07b falling due within a year, and liabilities of CN¥7.03b due beyond that. Offsetting this, it had CN¥1.49b in cash and CN¥3.27b in receivables that were due within 12 months. So its liabilities total CN¥4.33b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Jiangsu New Energy Development is worth CN¥10.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Jiangsu New Energy Development has a debt to EBITDA ratio of 2.5 and its EBIT covered its interest expense 3.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably Jiangsu New Energy Development's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Jiangsu New Energy Development 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Jiangsu New Energy Development recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Jiangsu New Energy Development's interest cover and its conversion of EBIT to free cash flow were discouraging. But its not so bad at (not) growing its EBIT. When we consider all the factors discussed, it seems to us that Jiangsu New Energy Development is taking some risks with its use of debt. 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. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Jiangsu New Energy Development (of which 1 is significant!) you should know about.

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.

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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.