Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that AECC Aviation Power Co.,Ltd (SHSE:600893) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

How Much Debt Does AECC Aviation PowerLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 AECC Aviation PowerLtd had CN¥8.15b of debt, an increase on CN¥3.10b, over one year. On the flip side, it has CN¥3.29b in cash leading to net debt of about CN¥4.86b.

How Healthy Is AECC Aviation PowerLtd's Balance Sheet?

We can see from the most recent balance sheet that AECC Aviation PowerLtd had liabilities of CN¥60.1b falling due within a year, and liabilities of -CN¥3.20b due beyond that. Offsetting this, it had CN¥3.29b in cash and CN¥26.5b in receivables that were due within 12 months. So its liabilities total CN¥27.2b more than the combination of its cash and short-term receivables.

AECC Aviation PowerLtd has a very large market capitalization of CN¥98.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

AECC Aviation PowerLtd has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 21.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that AECC Aviation PowerLtd grew its EBIT by 108% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if AECC Aviation PowerLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, AECC Aviation PowerLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen AECC Aviation PowerLtd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Considering this range of data points, we think AECC Aviation PowerLtd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for AECC Aviation PowerLtd that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.