Shandong Linglong TyreLtd (SHSE:601966) Takes On Some Risk With Its Use Of Debt

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.' 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. We can see that Shandong Linglong Tyre Co.,Ltd. (SHSE:601966) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shandong Linglong TyreLtd

How Much Debt Does Shandong Linglong TyreLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2023 Shandong Linglong TyreLtd had debt of CN¥11.7b, up from CN¥8.48b in one year. On the flip side, it has CN¥3.84b in cash leading to net debt of about CN¥7.83b.

How Strong Is Shandong Linglong TyreLtd's Balance Sheet?

We can see from the most recent balance sheet that Shandong Linglong TyreLtd had liabilities of CN¥17.8b falling due within a year, and liabilities of CN¥3.60b due beyond that. Offsetting this, it had CN¥3.84b in cash and CN¥4.45b in receivables that were due within 12 months. So its liabilities total CN¥13.1b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shandong Linglong TyreLtd has a market capitalization of CN¥31.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Shandong Linglong TyreLtd has net debt to EBITDA of 3.3 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.5 suggests it can easily service that debt. We also note that Shandong Linglong TyreLtd improved its EBIT from a last year's loss to a positive CN¥1.1b. 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 Shandong Linglong TyreLtd 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shandong Linglong TyreLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Shandong Linglong TyreLtd's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Shandong Linglong TyreLtd's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Over time, share prices tend to follow earnings per share, so if you're interested in Shandong Linglong TyreLtd, you may well want to click here to check an interactive graph of its earnings per share history.

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.