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.' 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 Zhejiang Windey Co.,Ltd. (SZSE:300772) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Zhejiang WindeyLtd

What Is Zhejiang WindeyLtd's Debt?

The image below, which you can click on for greater detail, shows that Zhejiang WindeyLtd had debt of CN¥749.9m at the end of March 2022, a reduction from CN¥991.7m over a year. However, its balance sheet shows it holds CN¥4.05b in cash, so it actually has CN¥3.30b net cash.

A Look At Zhejiang WindeyLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhejiang WindeyLtd had liabilities of CN¥19.3b due within 12 months and liabilities of CN¥2.48b due beyond that. On the other hand, it had cash of CN¥4.05b and CN¥8.58b worth of receivables due within a year. So its liabilities total CN¥9.10b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥13.5b, so it does suggest shareholders should keep an eye on Zhejiang WindeyLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, Zhejiang WindeyLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, Zhejiang WindeyLtd grew its EBIT by 295% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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 Zhejiang WindeyLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Zhejiang WindeyLtd 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, Zhejiang WindeyLtd recorded negative free cash flow, in total. 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.

Summing Up

Although Zhejiang WindeyLtd's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥3.30b. And we liked the look of last year's 295% year-on-year EBIT growth. So we don't have any problem with Zhejiang WindeyLtd's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Zhejiang WindeyLtd (of which 1 is a bit unpleasant!) you should know about.

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.

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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.