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.' 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 note that Zhejiang Zhongke Magnetic Industry Co., Ltd. (SZSE:301141) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Zhejiang Zhongke Magnetic Industry's Debt?

As you can see below, Zhejiang Zhongke Magnetic Industry had CN¥14.0m of debt at March 2024, down from CN¥37.1m a year prior. However, its balance sheet shows it holds CN¥788.1m in cash, so it actually has CN¥774.0m net cash.

A Look At Zhejiang Zhongke Magnetic Industry's Liabilities

According to the last reported balance sheet, Zhejiang Zhongke Magnetic Industry had liabilities of CN¥143.1m due within 12 months, and liabilities of CN¥15.4m due beyond 12 months. Offsetting these obligations, it had cash of CN¥788.1m as well as receivables valued at CN¥230.8m due within 12 months. So it actually has CN¥860.3m more liquid assets than total liabilities.

This surplus suggests that Zhejiang Zhongke Magnetic Industry is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Zhejiang Zhongke Magnetic Industry has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Zhejiang Zhongke Magnetic Industry's load is not too heavy, because its EBIT was down 96% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zhejiang Zhongke Magnetic Industry 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. While Zhejiang Zhongke Magnetic Industry has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Zhejiang Zhongke Magnetic Industry created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Zhejiang Zhongke Magnetic Industry has net cash of CN¥774.0m, as well as more liquid assets than liabilities. So we are not troubled with Zhejiang Zhongke Magnetic Industry's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Zhejiang Zhongke Magnetic Industry (including 1 which is a bit unpleasant) .

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.