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.' 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, Zhongshan Public Utilities Group Co.,Ltd (SZSE:000685) does carry debt. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhongshan Public Utilities GroupLtd's Net Debt?

As you can see below, at the end of June 2024, Zhongshan Public Utilities GroupLtd had CN¥8.09b of debt, up from CN¥7.12b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.78b, its net debt is less, at about CN¥6.31b.

A Look At Zhongshan Public Utilities GroupLtd's Liabilities

We can see from the most recent balance sheet that Zhongshan Public Utilities GroupLtd had liabilities of CN¥5.78b falling due within a year, and liabilities of CN¥7.50b due beyond that. Offsetting this, it had CN¥1.78b in cash and CN¥3.07b in receivables that were due within 12 months. So its liabilities total CN¥8.43b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥12.7b, so it does suggest shareholders should keep an eye on Zhongshan Public Utilities GroupLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Strangely Zhongshan Public Utilities GroupLtd has a sky high EBITDA ratio of 6.2, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. It is well worth noting that Zhongshan Public Utilities GroupLtd's EBIT shot up like bamboo after rain, gaining 31% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zhongshan Public Utilities GroupLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zhongshan Public Utilities GroupLtd 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

We feel some trepidation about Zhongshan Public Utilities GroupLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We should also note that Water Utilities industry companies like Zhongshan Public Utilities GroupLtd commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Zhongshan Public Utilities GroupLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 instance, we've identified 3 warning signs for Zhongshan Public Utilities GroupLtd (1 doesn't sit too well with us) you should be aware of.

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.