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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Chongqing Zhifei Biological Products Co., Ltd. (SZSE:300122) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Chongqing Zhifei Biological Products's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Chongqing Zhifei Biological Products had CN¥4.30b of debt, an increase on CN¥2.02b, over one year. However, it also had CN¥2.90b in cash, and so its net debt is CN¥1.40b.

How Strong Is Chongqing Zhifei Biological Products' Balance Sheet?

We can see from the most recent balance sheet that Chongqing Zhifei Biological Products had liabilities of CN¥18.6b falling due within a year, and liabilities of CN¥666.8m due beyond that. Offsetting this, it had CN¥2.90b in cash and CN¥28.6b in receivables that were due within 12 months. So it can boast CN¥12.2b more liquid assets than total liabilities.

This short term liquidity is a sign that Chongqing Zhifei Biological Products could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, Chongqing Zhifei Biological Products has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Chongqing Zhifei Biological Products has a low net debt to EBITDA ratio of only 0.14. And its EBIT covers its interest expense a whopping 961 times over. So we're pretty relaxed about its super-conservative use of debt. Also good is that Chongqing Zhifei Biological Products grew its EBIT at 15% over the last year, further increasing its ability to manage debt. 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 Chongqing Zhifei Biological Products 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Chongqing Zhifei Biological Products's free cash flow amounted to 33% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Chongqing Zhifei Biological Products's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Zooming out, Chongqing Zhifei Biological Products seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. Be aware that Chongqing Zhifei Biological Products is showing 1 warning sign in our investment analysis , 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.