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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Zhongfu Shenying Carbon Fiber Co.,Ltd. (SHSE:688295) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhongfu Shenying Carbon FiberLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Zhongfu Shenying Carbon FiberLtd had debt of CN¥2.58b, up from CN¥1.40b in one year. On the flip side, it has CN¥2.31b in cash leading to net debt of about CN¥271.2m.

A Look At Zhongfu Shenying Carbon FiberLtd's Liabilities

The latest balance sheet data shows that Zhongfu Shenying Carbon FiberLtd had liabilities of CN¥1.95b due within a year, and liabilities of CN¥2.96b falling due after that. Offsetting this, it had CN¥2.31b in cash and CN¥917.6m in receivables that were due within 12 months. So its liabilities total CN¥1.68b more than the combination of its cash and short-term receivables.

Of course, Zhongfu Shenying Carbon FiberLtd has a market capitalization of CN¥20.8b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Zhongfu Shenying Carbon FiberLtd 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhongfu Shenying Carbon FiberLtd's net debt is only 0.72 times its EBITDA. And its EBIT easily covers its interest expense, being 44.7 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Zhongfu Shenying Carbon FiberLtd's saving grace is its low debt levels, because its EBIT has tanked 82% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Zhongfu Shenying Carbon FiberLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Zhongfu Shenying Carbon FiberLtd 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

Neither Zhongfu Shenying Carbon FiberLtd's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Zhongfu Shenying Carbon FiberLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Zhongfu Shenying Carbon FiberLtd (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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.