Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Chongqing Yukaifa Co., Ltd (SZSE:000514) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Chongqing Yukaifa's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Chongqing Yukaifa had CN¥1.26b of debt, an increase on CN¥1.17b, over one year. However, it also had CN¥840.6m in cash, and so its net debt is CN¥417.9m.

How Healthy Is Chongqing Yukaifa's Balance Sheet?

We can see from the most recent balance sheet that Chongqing Yukaifa had liabilities of CN¥2.51b falling due within a year, and liabilities of CN¥1.12b due beyond that. Offsetting these obligations, it had cash of CN¥840.6m as well as receivables valued at CN¥317.6m due within 12 months. So its liabilities total CN¥2.48b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥3.77b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Chongqing Yukaifa's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 3.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Shareholders should be aware that Chongqing Yukaifa's EBIT was down 33% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Chongqing Yukaifa's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Chongqing Yukaifa generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Chongqing Yukaifa's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Chongqing Yukaifa is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Chongqing Yukaifa is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.