Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, ShenZhen Woer Heat-Shrinkable Material Co.,Ltd. (SZSE:002130) does carry debt. 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is ShenZhen Woer Heat-Shrinkable MaterialLtd's Net Debt?

As you can see below, ShenZhen Woer Heat-Shrinkable MaterialLtd had CN¥1.49b of debt at March 2024, down from CN¥1.67b a year prior. However, it also had CN¥1.06b in cash, and so its net debt is CN¥430.2m.

How Strong Is ShenZhen Woer Heat-Shrinkable MaterialLtd's Balance Sheet?

According to the last reported balance sheet, ShenZhen Woer Heat-Shrinkable MaterialLtd had liabilities of CN¥2.63b due within 12 months, and liabilities of CN¥944.6m due beyond 12 months. On the other hand, it had cash of CN¥1.06b and CN¥2.81b worth of receivables due within a year. So it can boast CN¥291.1m more liquid assets than total liabilities.

This state of affairs indicates that ShenZhen Woer Heat-Shrinkable MaterialLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥18.0b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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). 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).

ShenZhen Woer Heat-Shrinkable MaterialLtd has a low net debt to EBITDA ratio of only 0.36. And its EBIT covers its interest expense a whopping 27.9 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that ShenZhen Woer Heat-Shrinkable MaterialLtd has boosted its EBIT by 35%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ShenZhen Woer Heat-Shrinkable MaterialLtd's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, ShenZhen Woer Heat-Shrinkable MaterialLtd produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that ShenZhen Woer Heat-Shrinkable MaterialLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don't think ShenZhen Woer Heat-Shrinkable MaterialLtd is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. 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 example, we've discovered 2 warning signs for ShenZhen Woer Heat-Shrinkable MaterialLtd (1 is significant!) that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com