Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Anhui Yingliu Electromechanical Co., Ltd. (SHSE:603308) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Anhui Yingliu Electromechanical Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Anhui Yingliu Electromechanical had debt of CN¥4.56b, up from CN¥3.87b in one year. However, it does have CN¥655.9m in cash offsetting this, leading to net debt of about CN¥3.90b.

A Look At Anhui Yingliu Electromechanical's Liabilities

According to the last reported balance sheet, Anhui Yingliu Electromechanical had liabilities of CN¥3.15b due within 12 months, and liabilities of CN¥3.05b due beyond 12 months. Offsetting this, it had CN¥655.9m in cash and CN¥1.19b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.36b.

This deficit isn't so bad because Anhui Yingliu Electromechanical is worth CN¥10.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

With a net debt to EBITDA ratio of 6.5, it's fair to say Anhui Yingliu Electromechanical does have a significant amount of debt. However, its interest coverage of 3.3 is reasonably strong, which is a good sign. On a lighter note, we note that Anhui Yingliu Electromechanical grew its EBIT by 21% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Anhui Yingliu Electromechanical'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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Anhui Yingliu Electromechanical 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 Anhui Yingliu Electromechanical'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 at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Anhui Yingliu Electromechanical'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. 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 4 warning signs for Anhui Yingliu Electromechanical (of which 1 can't be ignored!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.