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.' 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. We can see that Zhe Jiang Headman Machinery Co.,Ltd. (SHSE:688577) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Zhe Jiang Headman MachineryLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Zhe Jiang Headman MachineryLtd had debt of CN¥93.5m, up from CN¥55.1m in one year. On the flip side, it has CN¥73.9m in cash leading to net debt of about CN¥19.6m.

A Look At Zhe Jiang Headman MachineryLtd's Liabilities

The latest balance sheet data shows that Zhe Jiang Headman MachineryLtd had liabilities of CN¥382.3m due within a year, and liabilities of CN¥86.5m falling due after that. Offsetting this, it had CN¥73.9m in cash and CN¥253.4m in receivables that were due within 12 months. So its liabilities total CN¥141.3m more than the combination of its cash and short-term receivables.

Given Zhe Jiang Headman MachineryLtd has a market capitalization of CN¥3.73b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Zhe Jiang Headman MachineryLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Zhe Jiang Headman MachineryLtd's net debt is only 0.30 times its EBITDA. And its EBIT covers its interest expense a whopping 15.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Zhe Jiang Headman MachineryLtd if management cannot prevent a repeat of the 48% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Zhe Jiang Headman MachineryLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Zhe Jiang Headman MachineryLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We feel some trepidation about Zhe Jiang Headman MachineryLtd's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Zhe Jiang Headman MachineryLtd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 instance, we've identified 3 warning signs for Zhe Jiang Headman MachineryLtd (2 are significant) you should be aware of.

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.