The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Zhejiang Int'l Group Co.,Ltd. (SZSE:000411) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Zhejiang Int'l GroupLtd Carry?

As you can see below, Zhejiang Int'l GroupLtd had CN¥3.84b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥1.32b in cash, and so its net debt is CN¥2.52b.

How Healthy Is Zhejiang Int'l GroupLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Int'l GroupLtd had liabilities of CN¥9.66b due within 12 months and liabilities of CN¥770.7m due beyond that. Offsetting these obligations, it had cash of CN¥1.32b as well as receivables valued at CN¥7.89b due within 12 months. So its liabilities total CN¥1.22b more than the combination of its cash and short-term receivables.

Zhejiang Int'l GroupLtd has a market capitalization of CN¥5.69b, so it could very likely raise cash to ameliorate 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhejiang Int'l GroupLtd's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Zhejiang Int'l GroupLtd grow its EBIT by 3.4% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhejiang Int'l GroupLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Considering the last three years, Zhejiang Int'l GroupLtd actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Zhejiang Int'l GroupLtd's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. When we consider all the factors discussed, it seems to us that Zhejiang Int'l GroupLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. We've identified 4 warning signs with Zhejiang Int'l GroupLtd (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

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.