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 can see that Zhonghang Electronic Measuring Instruments Co.,Ltd (SZSE:300114) does use debt in its business. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

What Is Zhonghang Electronic Measuring InstrumentsLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Zhonghang Electronic Measuring InstrumentsLtd had CN¥475.1m of debt, an increase on CN¥383.1m, over one year. However, because it has a cash reserve of CN¥311.3m, its net debt is less, at about CN¥163.8m.

How Strong Is Zhonghang Electronic Measuring InstrumentsLtd's Balance Sheet?

According to the last reported balance sheet, Zhonghang Electronic Measuring InstrumentsLtd had liabilities of CN¥1.07b due within 12 months, and liabilities of CN¥422.9m due beyond 12 months. Offsetting these obligations, it had cash of CN¥311.3m as well as receivables valued at CN¥1.17b due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that Zhonghang Electronic Measuring InstrumentsLtd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥28.4b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Zhonghang Electronic Measuring InstrumentsLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Zhonghang Electronic Measuring InstrumentsLtd's moderate net debt to EBITDA ratio ( being 1.5), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. The modesty of its debt load may become crucial for Zhonghang Electronic Measuring InstrumentsLtd if management cannot prevent a repeat of the 70% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhonghang Electronic Measuring InstrumentsLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Zhonghang Electronic Measuring InstrumentsLtd burned a lot of cash. 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

Neither Zhonghang Electronic Measuring InstrumentsLtd's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Zhonghang Electronic Measuring InstrumentsLtd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should be aware of the 1 warning sign we've spotted with Zhonghang Electronic Measuring InstrumentsLtd .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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