Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Zhonghang Electronic Measuring Instruments Co.,Ltd (SZSE:300114) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Zhonghang Electronic Measuring InstrumentsLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Zhonghang Electronic Measuring InstrumentsLtd had debt of CN¥442.8m, up from CN¥155.6m in one year. However, it does have CN¥390.3m in cash offsetting this, leading to net debt of about CN¥52.4m.

A Look At Zhonghang Electronic Measuring InstrumentsLtd's Liabilities

The latest balance sheet data shows that Zhonghang Electronic Measuring InstrumentsLtd had liabilities of CN¥1.26b due within a year, and liabilities of CN¥400.5m falling due after that. Offsetting these obligations, it had cash of CN¥390.3m as well as receivables valued at CN¥1.32b due within 12 months. So it can boast CN¥50.2m more liquid assets than total liabilities.

Having regard to Zhonghang Electronic Measuring InstrumentsLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥23.9b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Zhonghang Electronic Measuring InstrumentsLtd 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).

Zhonghang Electronic Measuring InstrumentsLtd has a low debt to EBITDA ratio of only 0.49. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. In fact Zhonghang Electronic Measuring InstrumentsLtd's saving grace is its low debt levels, because its EBIT has tanked 75% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Zhonghang Electronic Measuring InstrumentsLtd's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Zhonghang Electronic Measuring InstrumentsLtd 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 Zhonghang Electronic Measuring InstrumentsLtd's EBIT growth rate has us nervous. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. We think that Zhonghang Electronic Measuring InstrumentsLtd's debt does make it a bit risky, after considering the aforementioned data points together. 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Zhonghang Electronic Measuring InstrumentsLtd , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.