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 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. We can see that Zhejiang XCC Group Co.,Ltd (SHSE:603667) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Zhejiang XCC GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that Zhejiang XCC GroupLtd had debt of CN¥832.2m at the end of September 2023, a reduction from CN¥1.15b over a year. However, it also had CN¥695.1m in cash, and so its net debt is CN¥137.1m.

How Healthy Is Zhejiang XCC GroupLtd's Balance Sheet?

We can see from the most recent balance sheet that Zhejiang XCC GroupLtd had liabilities of CN¥1.53b falling due within a year, and liabilities of CN¥276.8m due beyond that. Offsetting these obligations, it had cash of CN¥695.1m as well as receivables valued at CN¥1.12b due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to Zhejiang XCC GroupLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥6.18b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Zhejiang XCC GroupLtd has a low net debt to EBITDA ratio of only 0.58. And its EBIT covers its interest expense a whopping 11.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Zhejiang XCC GroupLtd's saving grace is its low debt levels, because its EBIT has tanked 46% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhejiang XCC GroupLtd'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, Zhejiang XCC GroupLtd 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

Both Zhejiang XCC GroupLtd's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But at least its interest cover is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Zhejiang XCC GroupLtd is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Zhejiang XCC GroupLtd is showing 4 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.