Is Tongding Interconnection Information (SZSE:002491) 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.' 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. We note that Tongding Interconnection Information Co., Ltd. (SZSE:002491) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tongding Interconnection Information

What Is Tongding Interconnection Information's Net Debt?

The image below, which you can click on for greater detail, shows that Tongding Interconnection Information had debt of CN¥2.00b at the end of September 2023, a reduction from CN¥3.05b over a year. On the flip side, it has CN¥1.71b in cash leading to net debt of about CN¥286.0m.

How Healthy Is Tongding Interconnection Information's Balance Sheet?

We can see from the most recent balance sheet that Tongding Interconnection Information had liabilities of CN¥3.51b falling due within a year, and liabilities of CN¥71.1m due beyond that. Offsetting these obligations, it had cash of CN¥1.71b as well as receivables valued at CN¥1.47b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥398.7m.

Of course, Tongding Interconnection Information has a market capitalization of CN¥6.48b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Tongding Interconnection Information's net debt is only 0.95 times its EBITDA. And its EBIT covers its interest expense a whopping 88.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It was also good to see that despite losing money on the EBIT line last year, Tongding Interconnection Information turned things around in the last 12 months, delivering and EBIT of CN¥262m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tongding Interconnection Information will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Tongding Interconnection Information actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Tongding Interconnection Information's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, Tongding Interconnection Information seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Tongding Interconnection Information that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.