David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Guizhou Gas Group Corporation Ltd. (SHSE:600903) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Guizhou Gas Group's Net Debt?

As you can see below, at the end of March 2024, Guizhou Gas Group had CN¥5.43b of debt, up from CN¥5.10b a year ago. Click the image for more detail. However, it does have CN¥896.8m in cash offsetting this, leading to net debt of about CN¥4.54b.

How Healthy Is Guizhou Gas Group's Balance Sheet?

According to the last reported balance sheet, Guizhou Gas Group had liabilities of CN¥3.61b due within 12 months, and liabilities of CN¥3.30b due beyond 12 months. Offsetting this, it had CN¥896.8m in cash and CN¥1.17b in receivables that were due within 12 months. So its liabilities total CN¥4.85b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥7.19b, so it does suggest shareholders should keep an eye on Guizhou Gas Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Guizhou Gas Group shareholders face the double whammy of a high net debt to EBITDA ratio (6.7), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that Guizhou Gas Group actually let its EBIT decrease by 7.7% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Guizhou Gas Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, Guizhou Gas Group 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 Guizhou Gas Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its EBIT growth rate fails to inspire much confidence. Overall, it seems to us that Guizhou Gas Group's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 Guizhou Gas Group is showing 3 warning signs in our investment analysis , and 2 of those are potentially serious...

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.

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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.

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