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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Zhejiang Chint Electrics Co., Ltd. (SHSE:601877) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhejiang Chint Electrics's Debt?

As you can see below, at the end of September 2023, Zhejiang Chint Electrics had CN¥24.8b of debt, up from CN¥19.1b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥9.04b, its net debt is less, at about CN¥15.8b.

How Healthy Is Zhejiang Chint Electrics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Chint Electrics had liabilities of CN¥45.1b due within 12 months and liabilities of CN¥24.2b due beyond that. On the other hand, it had cash of CN¥9.04b and CN¥22.8b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥37.5b.

This is a mountain of leverage relative to its market capitalization of CN¥43.8b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhejiang Chint Electrics's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. We note that Zhejiang Chint Electrics grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhejiang Chint Electrics's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Zhejiang Chint Electrics burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Zhejiang Chint Electrics's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Zhejiang Chint Electrics's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Zhejiang Chint Electrics 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.