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 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 Wuxi Zhenhua Auto Parts Co.,Ltd. (SHSE:605319) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Wuxi Zhenhua Auto PartsLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Wuxi Zhenhua Auto PartsLtd had debt of CN¥680.6m, up from CN¥360.4m in one year. However, it also had CN¥348.8m in cash, and so its net debt is CN¥331.8m.

A Look At Wuxi Zhenhua Auto PartsLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Wuxi Zhenhua Auto PartsLtd had liabilities of CN¥2.15b due within 12 months and liabilities of CN¥109.3m due beyond that. Offsetting these obligations, it had cash of CN¥348.8m as well as receivables valued at CN¥1.38b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥526.0m.

Of course, Wuxi Zhenhua Auto PartsLtd has a market capitalization of CN¥4.81b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

Wuxi Zhenhua Auto PartsLtd has a low net debt to EBITDA ratio of only 0.91. And its EBIT easily covers its interest expense, being 11.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Wuxi Zhenhua Auto PartsLtd grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. 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 Wuxi Zhenhua Auto PartsLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Wuxi Zhenhua Auto PartsLtd burned a lot of cash. 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

Happily, Wuxi Zhenhua Auto PartsLtd's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Wuxi Zhenhua Auto PartsLtd can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For instance, we've identified 3 warning signs for Wuxi Zhenhua Auto PartsLtd (1 is potentially serious) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.