Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Jiangsu Tongrun Equipment Technology Co.,Ltd (SZSE:002150) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Jiangsu Tongrun Equipment TechnologyLtd's Net Debt?

As you can see below, at the end of September 2024, Jiangsu Tongrun Equipment TechnologyLtd had CN¥1.11b of debt, up from CN¥347.2m a year ago. Click the image for more detail. However, it also had CN¥1.06b in cash, and so its net debt is CN¥53.3m.

How Healthy Is Jiangsu Tongrun Equipment TechnologyLtd's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu Tongrun Equipment TechnologyLtd had liabilities of CN¥1.91b falling due within a year, and liabilities of CN¥741.9m due beyond that. Offsetting these obligations, it had cash of CN¥1.06b as well as receivables valued at CN¥941.9m due within 12 months. So it has liabilities totalling CN¥650.2m more than its cash and near-term receivables, combined.

Given Jiangsu Tongrun Equipment TechnologyLtd has a market capitalization of CN¥4.80b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Jiangsu Tongrun Equipment TechnologyLtd has a very light debt load indeed.

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).

Jiangsu Tongrun Equipment TechnologyLtd has a low net debt to EBITDA ratio of only 0.14. And its EBIT covers its interest expense a whopping 11.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Jiangsu Tongrun Equipment TechnologyLtd grew its EBIT by 115% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Jiangsu Tongrun Equipment TechnologyLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Jiangsu Tongrun Equipment TechnologyLtd's free cash flow amounted to 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Jiangsu Tongrun Equipment TechnologyLtd's impressive EBIT growth rate implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Zooming out, Jiangsu Tongrun Equipment TechnologyLtd seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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 learn about the 2 warning signs we've spotted with Jiangsu Tongrun Equipment TechnologyLtd (including 1 which makes us a bit uncomfortable) .

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.