David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Anhui Zhongding Sealing Parts Co., Ltd. (SZSE:000887) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

What Is Anhui Zhongding Sealing Parts's Debt?

As you can see below, at the end of March 2024, Anhui Zhongding Sealing Parts had CN¥5.59b of debt, up from CN¥5.24b a year ago. Click the image for more detail. On the flip side, it has CN¥2.72b in cash leading to net debt of about CN¥2.86b.

How Healthy Is Anhui Zhongding Sealing Parts' Balance Sheet?

We can see from the most recent balance sheet that Anhui Zhongding Sealing Parts had liabilities of CN¥7.45b falling due within a year, and liabilities of CN¥3.27b due beyond that. Offsetting these obligations, it had cash of CN¥2.72b as well as receivables valued at CN¥5.44b due within 12 months. So it has liabilities totalling CN¥2.56b more than its cash and near-term receivables, combined.

Given Anhui Zhongding Sealing Parts has a market capitalization of CN¥17.1b, it's hard to believe these liabilities pose much 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Anhui Zhongding Sealing Parts has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 22.4 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Anhui Zhongding Sealing Parts grew its EBIT by 51% over the last twelve months, and that growth will make it easier to handle its 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 Anhui Zhongding Sealing Parts 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Anhui Zhongding Sealing Parts reported free cash flow worth 8.0% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Anhui Zhongding Sealing Parts's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Anhui Zhongding Sealing Parts can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Anhui Zhongding Sealing Parts has 1 warning sign we think 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.