The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Zhuzhou Times New Material Technology Co., Ltd. (SHSE:600458) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

What Is Zhuzhou Times New Material Technology's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Zhuzhou Times New Material Technology had debt of CN¥2.36b, up from CN¥1.84b in one year. However, it also had CN¥1.60b in cash, and so its net debt is CN¥767.4m.

How Healthy Is Zhuzhou Times New Material Technology's Balance Sheet?

According to the last reported balance sheet, Zhuzhou Times New Material Technology had liabilities of CN¥9.43b due within 12 months, and liabilities of CN¥2.52b due beyond 12 months. Offsetting this, it had CN¥1.60b in cash and CN¥8.46b in receivables that were due within 12 months. So its liabilities total CN¥1.89b more than the combination of its cash and short-term receivables.

Zhuzhou Times New Material Technology has a market capitalization of CN¥8.95b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Zhuzhou Times New Material Technology has a low net debt to EBITDA ratio of only 0.85. And its EBIT easily covers its interest expense, being 12.3 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Zhuzhou Times New Material Technology grew its EBIT by 145% over twelve months. That boost will make it even 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 Zhuzhou Times New Material Technology 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Zhuzhou Times New Material Technology 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

Based on what we've seen Zhuzhou Times New Material Technology is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Zhuzhou Times New Material Technology is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that Zhuzhou Times New Material Technology is showing 2 warning signs in our investment analysis , you should know about...

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.