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. We can see that Eternal Asia Supply Chain Management Ltd. (SZSE:002183) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Eternal Asia Supply Chain Management's Debt?

The image below, which you can click on for greater detail, shows that Eternal Asia Supply Chain Management had debt of CN¥22.9b at the end of March 2024, a reduction from CN¥24.0b over a year. However, it also had CN¥10.3b in cash, and so its net debt is CN¥12.7b.

A Look At Eternal Asia Supply Chain Management's Liabilities

According to the last reported balance sheet, Eternal Asia Supply Chain Management had liabilities of CN¥37.6b due within 12 months, and liabilities of CN¥3.15b due beyond 12 months. Offsetting these obligations, it had cash of CN¥10.3b as well as receivables valued at CN¥18.7b due within 12 months. So its liabilities total CN¥11.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥7.89b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Eternal Asia Supply Chain Management would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 10.1 hit our confidence in Eternal Asia Supply Chain Management like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Eternal Asia Supply Chain Management saw its EBIT drop by 11% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Eternal Asia Supply Chain Management will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Eternal Asia Supply Chain Management actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Eternal Asia Supply Chain Management's interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. We think the chances that Eternal Asia Supply Chain Management has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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 Eternal Asia Supply Chain Management has 3 warning signs (and 1 which can't be ignored) we think 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com