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.' 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. Importantly, Guangdong Shenling Environmental Systems Co., Ltd. (SZSE:301018) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Guangdong Shenling Environmental Systems's Debt?

The image below, which you can click on for greater detail, shows that Guangdong Shenling Environmental Systems had debt of CN¥718.2m at the end of September 2024, a reduction from CN¥815.1m over a year. However, it does have CN¥703.5m in cash offsetting this, leading to net debt of about CN¥14.7m.

A Look At Guangdong Shenling Environmental Systems' Liabilities

The latest balance sheet data shows that Guangdong Shenling Environmental Systems had liabilities of CN¥2.00b due within a year, and liabilities of CN¥633.7m falling due after that. On the other hand, it had cash of CN¥703.5m and CN¥1.89b worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

Having regard to Guangdong Shenling Environmental Systems' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥6.51b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Guangdong Shenling Environmental Systems has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Guangdong Shenling Environmental Systems has very modest net debt, giving rise to a debt to EBITDA ratio of 0.095. And EBIT easily covered the interest expense 9.7 times over, lending force to that view. The modesty of its debt load may become crucial for Guangdong Shenling Environmental Systems if management cannot prevent a repeat of the 58% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guangdong Shenling Environmental Systems 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Guangdong Shenling Environmental Systems saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Both Guangdong Shenling Environmental Systems's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Guangdong Shenling Environmental Systems's debt poses some risks to the business. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Guangdong Shenling Environmental Systems has 2 warning signs we think 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.