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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Chongyi Zhangyuan Tungsten Co., Ltd. (SZSE:002378) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Chongyi Zhangyuan Tungsten's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Chongyi Zhangyuan Tungsten had CN¥1.98b of debt, an increase on CN¥1.50b, over one year. However, it also had CN¥660.5m in cash, and so its net debt is CN¥1.32b.

How Strong Is Chongyi Zhangyuan Tungsten's Balance Sheet?

According to the last reported balance sheet, Chongyi Zhangyuan Tungsten had liabilities of CN¥2.16b due within 12 months, and liabilities of CN¥670.6m due beyond 12 months. Offsetting this, it had CN¥660.5m in cash and CN¥572.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.60b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Chongyi Zhangyuan Tungsten has a market capitalization of CN¥7.79b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Chongyi Zhangyuan Tungsten has a debt to EBITDA ratio of 2.7, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. One way Chongyi Zhangyuan Tungsten could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. 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 Chongyi Zhangyuan Tungsten's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Chongyi Zhangyuan Tungsten created free cash flow amounting to 2.5% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On our analysis Chongyi Zhangyuan Tungsten's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. Considering this range of data points, we think Chongyi Zhangyuan Tungsten is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Chongyi Zhangyuan Tungsten is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.