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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Shanghai Zhenhua Heavy Industries Co., Ltd. (SHSE:900947) makes use of debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shanghai Zhenhua Heavy Industries

What Is Shanghai Zhenhua Heavy Industries's Debt?

The chart below, which you can click on for greater detail, shows that Shanghai Zhenhua Heavy Industries had CN¥31.7b in debt in June 2023; about the same as the year before. However, it also had CN¥6.38b in cash, and so its net debt is CN¥25.3b.

How Healthy Is Shanghai Zhenhua Heavy Industries' Balance Sheet?

According to the last reported balance sheet, Shanghai Zhenhua Heavy Industries had liabilities of CN¥47.7b due within 12 months, and liabilities of CN¥20.4b due beyond 12 months. Offsetting this, it had CN¥6.38b in cash and CN¥13.3b in receivables that were due within 12 months. So it has liabilities totalling CN¥48.4b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥15.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Shanghai Zhenhua Heavy Industries would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 9.4, it's fair to say Shanghai Zhenhua Heavy Industries does have a significant amount of debt. However, its interest coverage of 3.3 is reasonably strong, which is a good sign. However, it should be some comfort for shareholders to recall that Shanghai Zhenhua Heavy Industries actually grew its EBIT by a hefty 125%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Zhenhua Heavy Industries 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Shanghai Zhenhua Heavy Industries actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We feel some trepidation about Shanghai Zhenhua Heavy Industries's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Shanghai Zhenhua Heavy Industries is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Zhenhua Heavy Industries (of which 1 can't be ignored!) you should know about.

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.