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.' 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, AECC Aviation Power Co.,Ltd (SHSE:600893) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

How Much Debt Does AECC Aviation PowerLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 AECC Aviation PowerLtd had CN¥23.2b of debt, an increase on CN¥12.7b, over one year. On the flip side, it has CN¥3.67b in cash leading to net debt of about CN¥19.6b.

A Look At AECC Aviation PowerLtd's Liabilities

We can see from the most recent balance sheet that AECC Aviation PowerLtd had liabilities of CN¥72.9b falling due within a year, and liabilities of -CN¥4.85b due beyond that. Offsetting this, it had CN¥3.67b in cash and CN¥33.5b in receivables that were due within 12 months. So its liabilities total CN¥30.8b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because AECC Aviation PowerLtd is worth a massive CN¥109.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

AECC Aviation PowerLtd has a rather high debt to EBITDA ratio of 5.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 7.0 times, suggesting it can responsibly service its obligations. It is well worth noting that AECC Aviation PowerLtd's EBIT shot up like bamboo after rain, gaining 34% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if AECC Aviation PowerLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. During the last three years, AECC Aviation PowerLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither AECC Aviation PowerLtd's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that AECC Aviation PowerLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for AECC Aviation PowerLtd you should know about.

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.