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.' 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 can see that Nanjing Central Emporium (Group) Stocks Co., Ltd. (SHSE:600280) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Nanjing Central Emporium (Group) Stocks's Net Debt?

The chart below, which you can click on for greater detail, shows that Nanjing Central Emporium (Group) Stocks had CN¥5.91b in debt in September 2024; about the same as the year before. On the flip side, it has CN¥387.8m in cash leading to net debt of about CN¥5.53b.

How Healthy Is Nanjing Central Emporium (Group) Stocks' Balance Sheet?

We can see from the most recent balance sheet that Nanjing Central Emporium (Group) Stocks had liabilities of CN¥9.02b falling due within a year, and liabilities of CN¥1.46b due beyond that. On the other hand, it had cash of CN¥387.8m and CN¥247.0m worth of receivables due within a year. So it has liabilities totalling CN¥9.85b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥3.89b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Nanjing Central Emporium (Group) Stocks would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

With a net debt to EBITDA ratio of 14.3, it's fair to say Nanjing Central Emporium (Group) Stocks does have a significant amount of debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. Even worse, Nanjing Central Emporium (Group) Stocks saw its EBIT tank 25% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Nanjing Central Emporium (Group) Stocks will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Nanjing Central Emporium (Group) Stocks actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Nanjing Central Emporium (Group) Stocks's EBIT growth rate 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 conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Nanjing Central Emporium (Group) Stocks to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 example, we've discovered 2 warning signs for Nanjing Central Emporium (Group) Stocks (1 can't be ignored!) that you should be aware of before investing here.

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.