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 Longsheng Group Co.,Ltd (SHSE:600352) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Zhejiang Longsheng GroupLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Zhejiang Longsheng GroupLtd had debt of CN¥31.5b, up from CN¥23.8b in one year. However, because it has a cash reserve of CN¥20.6b, its net debt is less, at about CN¥11.0b.

How Strong Is Zhejiang Longsheng GroupLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Longsheng GroupLtd had liabilities of CN¥25.6b due within 12 months and liabilities of CN¥14.0b due beyond that. Offsetting this, it had CN¥20.6b in cash and CN¥4.31b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.7b.

Zhejiang Longsheng GroupLtd has a market capitalization of CN¥27.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Zhejiang Longsheng GroupLtd's net debt is 4.2 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that Zhejiang Longsheng GroupLtd's EBIT was down 43% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Zhejiang Longsheng GroupLtd 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, 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 Longsheng GroupLtd recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

While Zhejiang Longsheng GroupLtd's EBIT growth rate has us nervous. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Zhejiang Longsheng GroupLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Zhejiang Longsheng GroupLtd .

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.

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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