Is Shandong Linglong TyreLtd (SHSE:601966) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Shandong Linglong Tyre Co.,Ltd. (SHSE:601966) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shandong Linglong TyreLtd

What Is Shandong Linglong TyreLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shandong Linglong TyreLtd had CN¥12.8b of debt, an increase on CN¥10.8b, over one year. However, it does have CN¥3.95b in cash offsetting this, leading to net debt of about CN¥8.85b.

How Strong Is Shandong Linglong TyreLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shandong Linglong TyreLtd had liabilities of CN¥17.7b due within 12 months and liabilities of CN¥5.15b due beyond that. Offsetting this, it had CN¥3.95b in cash and CN¥4.69b in receivables that were due within 12 months. So its liabilities total CN¥14.2b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Shandong Linglong TyreLtd is worth CN¥23.7b, 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.

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

Shandong Linglong TyreLtd's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its strong interest cover of 11.0 times, makes us even more comfortable. Pleasingly, Shandong Linglong TyreLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 294% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shandong Linglong TyreLtd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Shandong Linglong TyreLtd 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

While Shandong Linglong TyreLtd's conversion of EBIT to free cash flow has us nervous. To wit both its EBIT growth rate and interest cover were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Shandong Linglong TyreLtd is a somewhat risky investment as a result of its debt. 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Shandong Linglong TyreLtd you should be aware of, and 1 of them makes us a bit uncomfortable.

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.