Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that China Grand Automotive Services Group Co.,Ltd (SHSE:600297) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does China Grand Automotive Services GroupLtd Carry?

You can click the graphic below for the historical numbers, but it shows that China Grand Automotive Services GroupLtd had CN¥46.3b of debt in March 2024, down from CN¥53.8b, one year before. On the flip side, it has CN¥8.34b in cash leading to net debt of about CN¥37.9b.

A Look At China Grand Automotive Services GroupLtd's Liabilities

According to the last reported balance sheet, China Grand Automotive Services GroupLtd had liabilities of CN¥53.3b due within 12 months, and liabilities of CN¥15.9b due beyond 12 months. Offsetting this, it had CN¥8.34b in cash and CN¥4.50b in receivables that were due within 12 months. So its liabilities total CN¥56.4b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥7.09b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, China Grand Automotive Services GroupLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 8.8 hit our confidence in China Grand Automotive Services GroupLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for China Grand Automotive Services GroupLtd is that it turned last year's EBIT loss into a gain of CN¥2.9b, over the last twelve months. 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 China Grand Automotive Services GroupLtd can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, China Grand Automotive Services GroupLtd recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both China Grand Automotive Services GroupLtd's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that China Grand Automotive Services GroupLtd's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for China Grand Automotive Services GroupLtd that you should be aware of.

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.

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