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.' 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. As with many other companies Canggang Railway Limited (HKG:2169) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Canggang Railway's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Canggang Railway had CN¥548.6m of debt, an increase on CN¥496.3m, over one year. However, it also had CN¥233.5m in cash, and so its net debt is CN¥315.1m.

How Healthy Is Canggang Railway's Balance Sheet?

We can see from the most recent balance sheet that Canggang Railway had liabilities of CN¥132.6m falling due within a year, and liabilities of CN¥460.8m due beyond that. On the other hand, it had cash of CN¥233.5m and CN¥84.0m worth of receivables due within a year. So its liabilities total CN¥276.0m more than the combination of its cash and short-term receivables.

Since publicly traded Canggang Railway shares are worth a total of CN¥3.45b, it seems unlikely that this level of liabilities would be a major threat. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Canggang Railway has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.8 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Canggang Railway's EBIT was down 21% last year. 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 you can't view debt in total isolation; since Canggang Railway 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Canggang Railway recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Canggang Railway's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its level of total liabilities is relatively strong. When we consider all the factors discussed, it seems to us that Canggang Railway is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Canggang Railway that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.