Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Zhefu Holding Group Co., Ltd. (SZSE:002266) does use debt in its business. But is this debt a concern to shareholders?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Zhefu Holding Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Zhefu Holding Group had CN¥5.67b of debt in September 2023, down from CN¥6.68b, one year before. However, it does have CN¥3.47b in cash offsetting this, leading to net debt of about CN¥2.20b.
A Look At Zhefu Holding Group's Liabilities
According to the last reported balance sheet, Zhefu Holding Group had liabilities of CN¥9.59b due within 12 months, and liabilities of CN¥1.79b due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.47b as well as receivables valued at CN¥1.56b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.34b.
This deficit isn't so bad because Zhefu Holding Group is worth CN¥17.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). 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).
Zhefu Holding Group has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 27.9 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Zhefu Holding Group grew its EBIT by 4.0% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhefu Holding Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Zhefu Holding Group saw substantial negative free cash flow, in total. 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
Neither Zhefu Holding Group's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Zhefu Holding Group 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Zhefu Holding Group you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.