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.' 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. Importantly, Guangzhou Hengyun Enterprises Holding Ltd (SZSE:000531) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

What Is Guangzhou Hengyun Enterprises Holding's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Guangzhou Hengyun Enterprises Holding had debt of CN¥11.2b, up from CN¥9.24b in one year. On the flip side, it has CN¥3.10b in cash leading to net debt of about CN¥8.14b.

A Look At Guangzhou Hengyun Enterprises Holding's Liabilities

According to the last reported balance sheet, Guangzhou Hengyun Enterprises Holding had liabilities of CN¥5.21b due within 12 months, and liabilities of CN¥8.00b due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.10b as well as receivables valued at CN¥560.9m due within 12 months. So its liabilities total CN¥9.55b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥5.19b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Guangzhou Hengyun Enterprises Holding would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

Strangely Guangzhou Hengyun Enterprises Holding has a sky high EBITDA ratio of 11.1, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably, Guangzhou Hengyun Enterprises Holding made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥358m in 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 Guangzhou Hengyun Enterprises Holding 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Guangzhou Hengyun Enterprises Holding 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

On the face of it, Guangzhou Hengyun Enterprises Holding's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Guangzhou Hengyun Enterprises Holding has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. We've identified 4 warning signs with Guangzhou Hengyun Enterprises Holding (at least 1 which is significant) , and understanding them should be part of your investment process.

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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