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. 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 Tian Chang Group Holdings Ltd. (HKG:2182) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Tian Chang Group Holdings

What Is Tian Chang Group Holdings's Net Debt?

As you can see below, Tian Chang Group Holdings had HK$118.3m of debt at June 2019, down from HK$288.5m a year prior. But it also has HK$122.4m in cash to offset that, meaning it has HK$4.09m net cash.

How Strong Is Tian Chang Group Holdings's Balance Sheet?

The latest balance sheet data shows that Tian Chang Group Holdings had liabilities of HK$350.8m due within a year, and liabilities of HK$54.2m falling due after that. Offsetting these obligations, it had cash of HK$122.4m as well as receivables valued at HK$91.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$191.2m.

This deficit isn't so bad because Tian Chang Group Holdings is worth HK$334.8m, 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. While it does have liabilities worth noting, Tian Chang Group Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, Tian Chang Group Holdings grew its EBIT by 256% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Tian Chang Group Holdings 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Tian Chang Group Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Tian Chang Group Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

Although Tian Chang Group Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$4.09m. The cherry on top was that in converted 110% of that EBIT to free cash flow, bringing in HK$229m. So is Tian Chang Group Holdings's debt a risk? It doesn't seem so to us. Another factor that would give us confidence in Tian Chang Group Holdings would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.