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.' 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. Importantly, Toly Bread Co.,Ltd. (SHSE:603866) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Toly BreadLtd's Debt?

As you can see below, at the end of September 2024, Toly BreadLtd had CN¥1.18b of debt, up from CN¥981.6m a year ago. Click the image for more detail. On the flip side, it has CN¥247.3m in cash leading to net debt of about CN¥935.8m.

How Strong Is Toly BreadLtd's Balance Sheet?

According to the last reported balance sheet, Toly BreadLtd had liabilities of CN¥1.67b due within 12 months, and liabilities of CN¥453.4m due beyond 12 months. Offsetting these obligations, it had cash of CN¥247.3m as well as receivables valued at CN¥506.1m due within 12 months. So it has liabilities totalling CN¥1.37b more than its cash and near-term receivables, combined.

Of course, Toly BreadLtd has a market capitalization of CN¥9.98b, 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.

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.

Toly BreadLtd has a low net debt to EBITDA ratio of only 0.97. And its EBIT covers its interest expense a whopping 39.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Toly BreadLtd saw its EBIT decline by 5.8% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Toly BreadLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Toly BreadLtd reported free cash flow worth 19% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

When it comes to the balance sheet, the standout positive for Toly BreadLtd was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Toly BreadLtd's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 1 warning sign for Toly BreadLtd that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.