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 Asia-potash International Investment (Guangzhou)Co.,Ltd. (SZSE:000893) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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.

How Much Debt Does Asia-potash International Investment (Guangzhou)Co.Ltd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Asia-potash International Investment (Guangzhou)Co.Ltd had CN¥2.08b of debt, an increase on CN¥526.6m, over one year. However, because it has a cash reserve of CN¥700.1m, its net debt is less, at about CN¥1.38b.

How Strong Is Asia-potash International Investment (Guangzhou)Co.Ltd's Balance Sheet?

The latest balance sheet data shows that Asia-potash International Investment (Guangzhou)Co.Ltd had liabilities of CN¥2.56b due within a year, and liabilities of CN¥1.82b falling due after that. On the other hand, it had cash of CN¥700.1m and CN¥43.1m worth of receivables due within a year. So its liabilities total CN¥3.64b more than the combination of its cash and short-term receivables.

Given Asia-potash International Investment (Guangzhou)Co.Ltd has a market capitalization of CN¥20.0b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Asia-potash International Investment (Guangzhou)Co.Ltd has a low net debt to EBITDA ratio of only 0.90. And its EBIT easily covers its interest expense, being 48.3 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Asia-potash International Investment (Guangzhou)Co.Ltd's saving grace is its low debt levels, because its EBIT has tanked 44% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Asia-potash International Investment (Guangzhou)Co.Ltd's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Asia-potash International Investment (Guangzhou)Co.Ltd 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

Neither Asia-potash International Investment (Guangzhou)Co.Ltd's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Asia-potash International Investment (Guangzhou)Co.Ltd 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. 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 Asia-potash International Investment (Guangzhou)Co.Ltd is showing 1 warning sign in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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