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. Importantly, ZHEJIANG NARADA POWER SOURCE Co. , Ltd. (SZSE:300068) does carry 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 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.

How Much Debt Does ZHEJIANG NARADA POWER SOURCE Carry?

As you can see below, at the end of March 2024, ZHEJIANG NARADA POWER SOURCE had CN¥8.02b of debt, up from CN¥5.17b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.10b, its net debt is less, at about CN¥5.93b.

How Healthy Is ZHEJIANG NARADA POWER SOURCE's Balance Sheet?

According to the last reported balance sheet, ZHEJIANG NARADA POWER SOURCE had liabilities of CN¥11.2b due within 12 months, and liabilities of CN¥3.67b due beyond 12 months. Offsetting this, it had CN¥2.10b in cash and CN¥4.36b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.36b.

When you consider that this deficiency exceeds the company's CN¥6.56b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

ZHEJIANG NARADA POWER SOURCE shareholders face the double whammy of a high net debt to EBITDA ratio (8.8), and fairly weak interest coverage, since EBIT is just 0.89 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, ZHEJIANG NARADA POWER SOURCE's EBIT was down 30% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 ZHEJIANG NARADA POWER SOURCE 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, ZHEJIANG NARADA POWER SOURCE 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

To be frank both ZHEJIANG NARADA POWER SOURCE's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering all the factors previously mentioned, we think that ZHEJIANG NARADA POWER SOURCE really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for ZHEJIANG NARADA POWER SOURCE you should be aware of, and 2 of them don't sit too well with us.

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.