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.' 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 Anhui Truchum Advanced Materials and Technology Co., Ltd. (SZSE:002171) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Anhui Truchum Advanced Materials and Technology's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Anhui Truchum Advanced Materials and Technology had CN¥10.1b of debt, an increase on CN¥7.84b, over one year. However, it also had CN¥3.28b in cash, and so its net debt is CN¥6.77b.

A Look At Anhui Truchum Advanced Materials and Technology's Liabilities

The latest balance sheet data shows that Anhui Truchum Advanced Materials and Technology had liabilities of CN¥9.92b due within a year, and liabilities of CN¥2.71b falling due after that. On the other hand, it had cash of CN¥3.28b and CN¥4.99b worth of receivables due within a year. So it has liabilities totalling CN¥4.36b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Anhui Truchum Advanced Materials and Technology is worth CN¥12.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 12.1 hit our confidence in Anhui Truchum Advanced Materials and Technology like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Anhui Truchum Advanced Materials and Technology's EBIT was down 32% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Anhui Truchum Advanced Materials and Technology's ability to maintain a healthy balance sheet going forward. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Anhui Truchum Advanced Materials and Technology burned a lot of cash. 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

To be frank both Anhui Truchum Advanced Materials and Technology's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Overall, it seems to us that Anhui Truchum Advanced Materials and Technology's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. We've identified 5 warning signs with Anhui Truchum Advanced Materials and Technology (at least 2 which are significant) , and understanding them should be part of your investment process.

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.