David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Guangxi Liugong Machinery Co., Ltd. (SZSE:000528) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Guangxi Liugong Machinery's Debt?

The image below, which you can click on for greater detail, shows that Guangxi Liugong Machinery had debt of CN¥9.22b at the end of September 2024, a reduction from CN¥12.1b over a year. On the flip side, it has CN¥8.02b in cash leading to net debt of about CN¥1.20b.

How Healthy Is Guangxi Liugong Machinery's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangxi Liugong Machinery had liabilities of CN¥22.0b due within 12 months and liabilities of CN¥5.92b due beyond that. Offsetting these obligations, it had cash of CN¥8.02b as well as receivables valued at CN¥12.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.22b.

Guangxi Liugong Machinery has a market capitalization of CN¥22.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Guangxi Liugong Machinery has a low net debt to EBITDA ratio of only 0.46. And its EBIT covers its interest expense a whopping 26.2 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Guangxi Liugong Machinery has boosted its EBIT by 59%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guangxi Liugong Machinery 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Guangxi Liugong Machinery recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Guangxi Liugong Machinery's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! When we consider the range of factors above, it looks like Guangxi Liugong Machinery is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. For instance, we've identified 1 warning sign for Guangxi Liugong Machinery 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.