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. As with many other companies Zhejiang TongLi Transmission Technology Co., Ltd. (SZSE:301255) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Zhejiang TongLi Transmission Technology Carry?
You can click the graphic below for the historical numbers, but it shows that Zhejiang TongLi Transmission Technology had CN¥28.5m of debt in September 2023, down from CN¥31.6m, one year before. But on the other hand it also has CN¥632.8m in cash, leading to a CN¥604.3m net cash position.
A Look At Zhejiang TongLi Transmission Technology's Liabilities
We can see from the most recent balance sheet that Zhejiang TongLi Transmission Technology had liabilities of CN¥202.6m falling due within a year, and liabilities of CN¥30.4m due beyond that. On the other hand, it had cash of CN¥632.8m and CN¥155.6m worth of receivables due within a year. So it actually has CN¥555.4m more liquid assets than total liabilities.
This excess liquidity suggests that Zhejiang TongLi Transmission Technology is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Zhejiang TongLi Transmission Technology boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Zhejiang TongLi Transmission Technology if management cannot prevent a repeat of the 21% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhejiang TongLi Transmission Technology will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Zhejiang TongLi Transmission Technology may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Zhejiang TongLi Transmission Technology recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Zhejiang TongLi Transmission Technology has net cash of CN¥604.3m, as well as more liquid assets than liabilities. So we don't have any problem with Zhejiang TongLi Transmission Technology's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Zhejiang TongLi Transmission Technology (of which 1 can't be ignored!) 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.