Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Henan Zhongfu Industrial Co.,Ltd (SHSE:600595) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Henan Zhongfu IndustrialLtd's Debt?

The chart below, which you can click on for greater detail, shows that Henan Zhongfu IndustrialLtd had CN¥4.30b in debt in March 2024; about the same as the year before. On the flip side, it has CN¥807.7m in cash leading to net debt of about CN¥3.49b.

A Look At Henan Zhongfu IndustrialLtd's Liabilities

According to the last reported balance sheet, Henan Zhongfu IndustrialLtd had liabilities of CN¥4.87b due within 12 months, and liabilities of CN¥3.35b due beyond 12 months. On the other hand, it had cash of CN¥807.7m and CN¥1.78b worth of receivables due within a year. So its liabilities total CN¥5.64b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Henan Zhongfu IndustrialLtd has a market capitalization of CN¥12.4b, 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 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).

Looking at its net debt to EBITDA of 1.4 and interest cover of 6.2 times, it seems to us that Henan Zhongfu IndustrialLtd is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. In addition to that, we're happy to report that Henan Zhongfu IndustrialLtd has boosted its EBIT by 35%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Henan Zhongfu IndustrialLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Henan Zhongfu IndustrialLtd produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Henan Zhongfu IndustrialLtd's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Taking all this data into account, it seems to us that Henan Zhongfu IndustrialLtd takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Henan Zhongfu IndustrialLtd's earnings per share history for free.

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.