The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Tongcheng Travel Holdings Limited (HKG:780) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

What Is Tongcheng Travel Holdings's Net Debt?

As you can see below, at the end of June 2024, Tongcheng Travel Holdings had CN¥3.12b of debt, up from CN¥2.18b a year ago. Click the image for more detail. But on the other hand it also has CN¥10.2b in cash, leading to a CN¥7.04b net cash position.

A Look At Tongcheng Travel Holdings' Liabilities

We can see from the most recent balance sheet that Tongcheng Travel Holdings had liabilities of CN¥12.9b falling due within a year, and liabilities of CN¥2.19b due beyond that. Offsetting this, it had CN¥10.2b in cash and CN¥2.14b in receivables that were due within 12 months. So its liabilities total CN¥2.78b more than the combination of its cash and short-term receivables.

Of course, Tongcheng Travel Holdings has a market capitalization of CN¥37.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Tongcheng Travel Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Tongcheng Travel Holdings grew its EBIT by 112% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Tongcheng Travel Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Tongcheng Travel Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Tongcheng Travel Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

We could understand if investors are concerned about Tongcheng Travel Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥7.04b. And it impressed us with free cash flow of CN¥2.0b, being 154% of its EBIT. So we don't think Tongcheng Travel Holdings's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Tongcheng Travel Holdings .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.