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 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 TCL Zhonghuan Renewable Energy Technology Co.,Ltd. (SZSE:002129) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is TCL Zhonghuan Renewable Energy TechnologyLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 TCL Zhonghuan Renewable Energy TechnologyLtd had CN¥40.2b of debt, an increase on CN¥37.8b, over one year. On the flip side, it has CN¥11.0b in cash leading to net debt of about CN¥29.1b.

How Strong Is TCL Zhonghuan Renewable Energy TechnologyLtd's Balance Sheet?

The latest balance sheet data shows that TCL Zhonghuan Renewable Energy TechnologyLtd had liabilities of CN¥22.4b due within a year, and liabilities of CN¥43.2b falling due after that. Offsetting this, it had CN¥11.0b in cash and CN¥10.9b in receivables that were due within 12 months. So it has liabilities totalling CN¥43.7b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥40.5b, we think shareholders really should watch TCL Zhonghuan Renewable Energy TechnologyLtd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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).

With a debt to EBITDA ratio of 2.3, TCL Zhonghuan Renewable Energy TechnologyLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. Importantly, TCL Zhonghuan Renewable Energy TechnologyLtd's EBIT fell a jaw-dropping 51% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 TCL Zhonghuan Renewable Energy TechnologyLtd can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, TCL Zhonghuan Renewable Energy TechnologyLtd 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

To be frank both TCL Zhonghuan Renewable Energy TechnologyLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like TCL Zhonghuan Renewable Energy TechnologyLtd 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that TCL Zhonghuan Renewable Energy TechnologyLtd is showing 4 warning signs in our investment analysis , and 2 of those are significant...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.