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 Chongqing Zongshen Power Machinery Co.,Ltd (SZSE:001696) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 think about a company's use of debt, we first look at cash and debt together.

What Is Chongqing Zongshen Power MachineryLtd's Net Debt?

As you can see below, at the end of March 2024, Chongqing Zongshen Power MachineryLtd had CN¥2.21b of debt, up from CN¥1.26b a year ago. Click the image for more detail. But on the other hand it also has CN¥2.41b in cash, leading to a CN¥200.6m net cash position.

How Healthy Is Chongqing Zongshen Power MachineryLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chongqing Zongshen Power MachineryLtd had liabilities of CN¥2.72b due within 12 months and liabilities of CN¥2.96b due beyond that. Offsetting this, it had CN¥2.41b in cash and CN¥2.79b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥483.7m.

Given Chongqing Zongshen Power MachineryLtd has a market capitalization of CN¥12.1b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Chongqing Zongshen Power MachineryLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

Another good sign is that Chongqing Zongshen Power MachineryLtd has been able to increase its EBIT by 22% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chongqing Zongshen Power MachineryLtd'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Chongqing Zongshen Power MachineryLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Chongqing Zongshen Power MachineryLtd recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Chongqing Zongshen Power MachineryLtd has CN¥200.6m in net cash. And it impressed us with free cash flow of CN¥68m, being 82% of its EBIT. So is Chongqing Zongshen Power MachineryLtd's debt a risk? It doesn't seem so to us. 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. To that end, you should learn about the 2 warning signs we've spotted with Chongqing Zongshen Power MachineryLtd (including 1 which doesn't sit too well with us) .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com