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. Importantly, Zhejiang Yonghe Refrigerant Co., Ltd. (SHSE:605020) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Zhejiang Yonghe Refrigerant
How Much Debt Does Zhejiang Yonghe Refrigerant Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2023 Zhejiang Yonghe Refrigerant had CN¥2.21b of debt, an increase on CN¥897.3m, over one year. However, because it has a cash reserve of CN¥170.4m, its net debt is less, at about CN¥2.04b.
How Strong Is Zhejiang Yonghe Refrigerant's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Zhejiang Yonghe Refrigerant had liabilities of CN¥2.44b due within 12 months and liabilities of CN¥1.33b due beyond that. Offsetting these obligations, it had cash of CN¥170.4m as well as receivables valued at CN¥811.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.79b.
While this might seem like a lot, it is not so bad since Zhejiang Yonghe Refrigerant has a market capitalization of CN¥9.93b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Zhejiang Yonghe Refrigerant has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 6.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Zhejiang Yonghe Refrigerant's EBIT flopped 19% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Yonghe Refrigerant 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. Over the last three years, Zhejiang Yonghe Refrigerant saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
On the face of it, Zhejiang Yonghe Refrigerant's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Overall, it seems to us that Zhejiang Yonghe Refrigerant's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 4 warning signs for Zhejiang Yonghe Refrigerant (2 are a bit unpleasant!) that you should be aware of before investing here.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.