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. We can see that Ningxia Qinglong Pipes Industry Group Co., Ltd. (SZSE:002457) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Ningxia Qinglong Pipes Industry Group's Debt?

As you can see below, at the end of September 2024, Ningxia Qinglong Pipes Industry Group had CN¥733.7m of debt, up from CN¥656.2m a year ago. Click the image for more detail. However, it also had CN¥540.9m in cash, and so its net debt is CN¥192.9m.

How Healthy Is Ningxia Qinglong Pipes Industry Group's Balance Sheet?

We can see from the most recent balance sheet that Ningxia Qinglong Pipes Industry Group had liabilities of CN¥1.87b falling due within a year, and liabilities of CN¥68.7m due beyond that. On the other hand, it had cash of CN¥540.9m and CN¥1.48b worth of receivables due within a year. So it can boast CN¥82.9m more liquid assets than total liabilities.

Having regard to Ningxia Qinglong Pipes Industry Group's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥4.53b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Ningxia Qinglong Pipes Industry Group has a low net debt to EBITDA ratio of only 0.81. And its EBIT easily covers its interest expense, being 24.9 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Ningxia Qinglong Pipes Industry Group grew its EBIT by 49% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ningxia Qinglong Pipes Industry Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Ningxia Qinglong Pipes Industry Group's free cash flow amounted to 27% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Ningxia Qinglong Pipes Industry Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at the bigger picture, we think Ningxia Qinglong Pipes Industry Group's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Ningxia Qinglong Pipes Industry Group (of which 1 is a bit unpleasant!) you should know about.

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.