Warren Buffett famously said, '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. We note that Huludao Zinc Industry Co.,Ltd. (SZSE:000751) does have debt on its balance sheet. 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, 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 Huludao Zinc IndustryLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Huludao Zinc IndustryLtd had CN¥2.92b of debt, an increase on CN¥2.57b, over one year. However, it does have CN¥1.64b in cash offsetting this, leading to net debt of about CN¥1.28b.

How Strong Is Huludao Zinc IndustryLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Huludao Zinc IndustryLtd had liabilities of CN¥5.46b due within 12 months and liabilities of CN¥184.0m due beyond that. On the other hand, it had cash of CN¥1.64b and CN¥460.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.55b.

This deficit is considerable relative to its market capitalization of CN¥5.15b, so it does suggest shareholders should keep an eye on Huludao Zinc IndustryLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

While Huludao Zinc IndustryLtd's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 1.4, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Huludao Zinc IndustryLtd's EBIT was down 22% 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 it is Huludao Zinc IndustryLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Huludao Zinc IndustryLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Huludao Zinc IndustryLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. After considering the datapoints discussed, we think Huludao Zinc IndustryLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example, we've discovered 4 warning signs for Huludao Zinc IndustryLtd (2 are concerning!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.