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 Guangzhou Restaurant Group Company Limited (SHSE:603043) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Guangzhou Restaurant Group Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Guangzhou Restaurant Group had debt of CN¥551.8m, up from CN¥503.5m in one year. But it also has CN¥1.25b in cash to offset that, meaning it has CN¥701.8m net cash.

A Look At Guangzhou Restaurant Group's Liabilities

We can see from the most recent balance sheet that Guangzhou Restaurant Group had liabilities of CN¥1.58b falling due within a year, and liabilities of CN¥828.3m due beyond that. Offsetting this, it had CN¥1.25b in cash and CN¥233.3m in receivables that were due within 12 months. So its liabilities total CN¥917.6m more than the combination of its cash and short-term receivables.

Of course, Guangzhou Restaurant Group has a market capitalization of CN¥8.43b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Guangzhou Restaurant Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Also good is that Guangzhou Restaurant Group grew its EBIT at 14% over the last year, further increasing its ability to manage debt. 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 Guangzhou Restaurant Group 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. Guangzhou Restaurant Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Guangzhou Restaurant Group recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

Although Guangzhou Restaurant Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥701.8m. The cherry on top was that in converted 75% of that EBIT to free cash flow, bringing in CN¥661m. So we don't think Guangzhou Restaurant Group's use of debt is risky. 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. Be aware that Guangzhou Restaurant Group is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.

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