Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Guangdong Huiyun Titanium Industry Co., Ltd. (SZSE:300891) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Guangdong Huiyun Titanium Industry's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Guangdong Huiyun Titanium Industry had CN¥962.7m of debt, an increase on CN¥814.5m, over one year. However, it also had CN¥189.6m in cash, and so its net debt is CN¥773.0m.

How Strong Is Guangdong Huiyun Titanium Industry's Balance Sheet?

We can see from the most recent balance sheet that Guangdong Huiyun Titanium Industry had liabilities of CN¥913.7m falling due within a year, and liabilities of CN¥526.9m due beyond that. Offsetting these obligations, it had cash of CN¥189.6m as well as receivables valued at CN¥370.7m due within 12 months. So its liabilities total CN¥880.4m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Guangdong Huiyun Titanium Industry has a market capitalization of CN¥3.54b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a net debt to EBITDA ratio of 6.2, it's fair to say Guangdong Huiyun Titanium Industry does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.9 times, suggesting it can responsibly service its obligations. We also note that Guangdong Huiyun Titanium Industry improved its EBIT from a last year's loss to a positive CN¥43m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Guangdong Huiyun Titanium Industry's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Guangdong Huiyun Titanium Industry saw substantial negative free cash flow, in total. 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

To be frank both Guangdong Huiyun Titanium Industry's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Guangdong Huiyun Titanium Industry'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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Guangdong Huiyun Titanium Industry is showing 4 warning signs in our investment analysis , and 3 of those can't be ignored...

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.