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 Zhe Jiang Taihua New Material Co., Ltd. (SHSE:603055) does use debt in its business. But the more important question is: how much risk is that debt creating?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Zhe Jiang Taihua New Material

What Is Zhe Jiang Taihua New Material's Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Zhe Jiang Taihua New Material had debt of CN¥1.80b, up from CN¥1.52b in one year. On the flip side, it has CN¥1.01b in cash leading to net debt of about CN¥786.2m.

A Look At Zhe Jiang Taihua New Material's Liabilities

The latest balance sheet data shows that Zhe Jiang Taihua New Material had liabilities of CN¥2.00b due within a year, and liabilities of CN¥1.32b falling due after that. Offsetting these obligations, it had cash of CN¥1.01b as well as receivables valued at CN¥826.2m due within 12 months. So it has liabilities totalling CN¥1.49b more than its cash and near-term receivables, combined.

Since publicly traded Zhe Jiang Taihua New Material shares are worth a total of CN¥8.25b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Zhe Jiang Taihua New Material has net debt of just 0.91 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.9 times the interest expense over the last year. Better yet, Zhe Jiang Taihua New Material grew its EBIT by 116% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Zhe Jiang Taihua New Material 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Zhe Jiang Taihua New Material 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

Based on what we've seen Zhe Jiang Taihua New Material is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. Considering this range of data points, we think Zhe Jiang Taihua New Material is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 3 warning signs for Zhe Jiang Taihua New Material that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.