Is China Testing & Certification International GroupLtd (SHSE:603060) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 China Testing & Certification International Group Co.,Ltd. (SHSE:603060) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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.

See our latest analysis for China Testing & Certification International GroupLtd

How Much Debt Does China Testing & Certification International GroupLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 China Testing & Certification International GroupLtd had CN¥1.34b of debt, an increase on CN¥1.09b, over one year. On the flip side, it has CN¥226.9m in cash leading to net debt of about CN¥1.12b.

How Healthy Is China Testing & Certification International GroupLtd's Balance Sheet?

According to the last reported balance sheet, China Testing & Certification International GroupLtd had liabilities of CN¥1.85b due within 12 months, and liabilities of CN¥728.5m due beyond 12 months. Offsetting these obligations, it had cash of CN¥226.9m as well as receivables valued at CN¥1.46b due within 12 months. So its liabilities total CN¥891.3m more than the combination of its cash and short-term receivables.

Since publicly traded China Testing & Certification International GroupLtd shares are worth a total of CN¥4.90b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 2.2, China Testing & Certification International GroupLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.9 times interest expense) certainly does not do anything to dispel this impression. We saw China Testing & Certification International GroupLtd grow its EBIT by 2.4% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 China Testing & Certification International GroupLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Testing & Certification International GroupLtd recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

China Testing & Certification International GroupLtd's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that China Testing & Certification International GroupLtd 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 3 warning signs for China Testing & Certification International GroupLtd 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.