We Think Shandong Linglong TyreLtd (SHSE:601966) Is Taking Some Risk With Its 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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shandong Linglong Tyre Co.,Ltd. (SHSE:601966) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at 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 March 2024 Shandong Linglong TyreLtd had debt of CN¥12.6b, up from CN¥9.15b in one year. On the flip side, it has CN¥4.22b in cash leading to net debt of about CN¥8.40b.

A Look At Shandong Linglong TyreLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Shandong Linglong TyreLtd had liabilities of CN¥18.1b due within 12 months and liabilities of CN¥4.88b due beyond that. Offsetting these obligations, it had cash of CN¥4.22b as well as receivables valued at CN¥4.65b due within 12 months. So its liabilities total CN¥14.1b more than the combination of its cash and short-term receivables.

Shandong Linglong TyreLtd has a market capitalization of CN¥30.9b, so it could very likely raise cash to ameliorate 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.

Shandong Linglong TyreLtd has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.2 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. Pleasingly, Shandong Linglong TyreLtd is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 385% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shandong Linglong TyreLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shandong Linglong TyreLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shandong Linglong TyreLtd's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. 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. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Shandong Linglong TyreLtd has 1 warning sign we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.