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 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 Zhejiang Wanliyang Co., Ltd. (SZSE:002434) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Zhejiang Wanliyang's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Zhejiang Wanliyang had debt of CN¥2.18b, up from CN¥1.45b in one year. However, because it has a cash reserve of CN¥932.4m, its net debt is less, at about CN¥1.25b.

A Look At Zhejiang Wanliyang's Liabilities

The latest balance sheet data shows that Zhejiang Wanliyang had liabilities of CN¥4.20b due within a year, and liabilities of CN¥871.0m falling due after that. Offsetting these obligations, it had cash of CN¥932.4m as well as receivables valued at CN¥2.32b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.82b.

While this might seem like a lot, it is not so bad since Zhejiang Wanliyang has a market capitalization of CN¥6.80b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhejiang Wanliyang's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 6.7 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. We note that Zhejiang Wanliyang grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Zhejiang Wanliyang 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.

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. Over the last three years, Zhejiang Wanliyang saw substantial negative free cash flow, in total. 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 Zhejiang Wanliyang 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. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Zhejiang Wanliyang's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Zhejiang Wanliyang has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.