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.' 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 note that Guangdong Create Century Intelligent Equipment Group Corporation Limited (SZSE:300083) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Guangdong Create Century Intelligent Equipment Group Carry?

The image below, which you can click on for greater detail, shows that Guangdong Create Century Intelligent Equipment Group had debt of CN¥1.64b at the end of June 2024, a reduction from CN¥1.89b over a year. However, it also had CN¥1.27b in cash, and so its net debt is CN¥366.1m.

How Strong Is Guangdong Create Century Intelligent Equipment Group's Balance Sheet?

The latest balance sheet data shows that Guangdong Create Century Intelligent Equipment Group had liabilities of CN¥4.06b due within a year, and liabilities of CN¥819.3m falling due after that. Offsetting these obligations, it had cash of CN¥1.27b as well as receivables valued at CN¥2.48b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.13b.

Of course, Guangdong Create Century Intelligent Equipment Group has a market capitalization of CN¥9.81b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Even though Guangdong Create Century Intelligent Equipment Group's debt is only 2.2, its interest cover is really very low at 2.3. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Importantly, Guangdong Create Century Intelligent Equipment Group's EBIT fell a jaw-dropping 79% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guangdong Create Century Intelligent Equipment Group 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Guangdong Create Century Intelligent Equipment Group created free cash flow amounting to 19% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Guangdong Create Century Intelligent Equipment Group's EBIT growth rate was disappointing. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Once we consider all the factors above, together, it seems to us that Guangdong Create Century Intelligent Equipment Group's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 2 warning signs for Guangdong Create Century Intelligent Equipment Group 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.