Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Zhejiang Songyuan Automotive Safety Systems Co.,Ltd. (SZSE:300893) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Zhejiang Songyuan Automotive Safety SystemsLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Zhejiang Songyuan Automotive Safety SystemsLtd had CN¥564.1m of debt, an increase on CN¥346.3m, over one year. On the flip side, it has CN¥158.3m in cash leading to net debt of about CN¥405.8m.

A Look At Zhejiang Songyuan Automotive Safety SystemsLtd's Liabilities

According to the last reported balance sheet, Zhejiang Songyuan Automotive Safety SystemsLtd had liabilities of CN¥498.6m due within 12 months, and liabilities of CN¥457.5m due beyond 12 months. Offsetting this, it had CN¥158.3m in cash and CN¥686.9m in receivables that were due within 12 months. So its liabilities total CN¥110.9m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Zhejiang Songyuan Automotive Safety SystemsLtd'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¥6.42b company is short on cash, but still worth keeping an eye on the balance sheet.

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).

Zhejiang Songyuan Automotive Safety SystemsLtd's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 29.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Zhejiang Songyuan Automotive Safety SystemsLtd grew its EBIT by 89% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhejiang Songyuan Automotive Safety SystemsLtd'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Zhejiang Songyuan Automotive Safety SystemsLtd 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

Happily, Zhejiang Songyuan Automotive Safety SystemsLtd's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Zhejiang Songyuan Automotive Safety SystemsLtd can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Zhejiang Songyuan Automotive Safety SystemsLtd has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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