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 Shuanghuan Driveline Co.,Ltd. (SZSE:002472) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Zhejiang Shuanghuan DrivelineLtd Carry?

As you can see below, Zhejiang Shuanghuan DrivelineLtd had CN¥2.12b of debt at September 2023, down from CN¥3.52b a year prior. However, because it has a cash reserve of CN¥1.39b, its net debt is less, at about CN¥738.5m.

How Strong Is Zhejiang Shuanghuan DrivelineLtd's Balance Sheet?

The latest balance sheet data shows that Zhejiang Shuanghuan DrivelineLtd had liabilities of CN¥3.80b due within a year, and liabilities of CN¥1.27b falling due after that. Offsetting this, it had CN¥1.39b in cash and CN¥2.36b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.32b.

Of course, Zhejiang Shuanghuan DrivelineLtd has a market capitalization of CN¥19.2b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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 Shuanghuan DrivelineLtd has a low net debt to EBITDA ratio of only 0.52. And its EBIT easily covers its interest expense, being 15.0 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, Zhejiang Shuanghuan DrivelineLtd grew its EBIT by 28% 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 Zhejiang Shuanghuan DrivelineLtd 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, 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. Considering the last three years, Zhejiang Shuanghuan DrivelineLtd actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

The good news is that Zhejiang Shuanghuan DrivelineLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. When we consider the range of factors above, it looks like Zhejiang Shuanghuan DrivelineLtd is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in Zhejiang Shuanghuan DrivelineLtd, you may well want to click here to check an interactive graph of its earnings per share history.

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.