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.' 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. We can see that Zhe Jiang Taihua New Material Co., Ltd. (SHSE:603055) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Zhe Jiang Taihua New Material

How Much Debt Does Zhe Jiang Taihua New Material Carry?

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. However, it does have CN¥1.01b in cash offsetting this, leading to net debt of about CN¥786.2m.

A Look At Zhe Jiang Taihua New Material's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhe Jiang Taihua New Material had liabilities of CN¥2.00b due within 12 months and liabilities of CN¥1.32b due beyond 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 its liabilities total CN¥1.49b more than the combination of its cash and short-term receivables.

Since publicly traded Zhe Jiang Taihua New Material shares are worth a total of CN¥10.3b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Zhe Jiang Taihua New Material has net debt of just 0.91 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.9 times, which is more than adequate. Better yet, Zhe Jiang Taihua New Material grew its EBIT by 116% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Zhe Jiang Taihua New Material 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

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. When we consider all the elements mentioned above, it seems to us that Zhe Jiang Taihua New Material is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Zhe Jiang Taihua New Material , and understanding them should be part of your investment process.

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.