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. We can see that Zhejiang Wanfeng Auto Wheel Co., Ltd. (SZSE:002085) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhejiang Wanfeng Auto Wheel's Debt?

As you can see below, Zhejiang Wanfeng Auto Wheel had CN¥4.33b of debt at March 2024, down from CN¥5.39b a year prior. However, because it has a cash reserve of CN¥1.92b, its net debt is less, at about CN¥2.41b.

How Healthy Is Zhejiang Wanfeng Auto Wheel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Wanfeng Auto Wheel had liabilities of CN¥6.96b due within 12 months and liabilities of CN¥1.18b due beyond that. Offsetting these obligations, it had cash of CN¥1.92b as well as receivables valued at CN¥4.38b due within 12 months. So its liabilities total CN¥1.83b more than the combination of its cash and short-term receivables.

Since publicly traded Zhejiang Wanfeng Auto Wheel shares are worth a total of CN¥30.9b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhejiang Wanfeng Auto Wheel has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.6 times, which is more than adequate. Fortunately, Zhejiang Wanfeng Auto Wheel grew its EBIT by 8.3% in the last year, making that debt load look even more manageable. 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 Wanfeng Auto Wheel 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Zhejiang Wanfeng Auto Wheel recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Zhejiang Wanfeng Auto Wheel's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And its net debt to EBITDA is good too. When we consider the range of factors above, it looks like Zhejiang Wanfeng Auto Wheel is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. We've identified 3 warning signs with Zhejiang Wanfeng Auto Wheel (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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.

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