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.' 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 Zhejiang Chint Electrics Co., Ltd. (SHSE:601877) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. 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. 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.
Check out our latest analysis for Zhejiang Chint Electrics
How Much Debt Does Zhejiang Chint Electrics Carry?
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. On the flip side, it has CN¥9.04b in cash leading to net debt of about CN¥15.8b.
How Strong 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. Offsetting these obligations, it had cash of CN¥9.04b as well as receivables valued at CN¥22.8b due within 12 months. So its liabilities total CN¥37.5b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of CN¥50.3b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). 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 strong interest cover of 1k times, makes us even more comfortable. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhejiang Chint Electrics 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Zhejiang Chint Electrics burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
While Zhejiang Chint Electrics's conversion of EBIT to free cash flow has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Zhejiang Chint Electrics is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Zhejiang Chint Electrics , 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.