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.' 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 Zhejiang Xinao Textiles Inc. (SHSE:603889) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhejiang Xinao Textiles's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Zhejiang Xinao Textiles had debt of CN¥1.59b, up from CN¥1.13b in one year. However, because it has a cash reserve of CN¥912.3m, its net debt is less, at about CN¥674.2m.

How Healthy Is Zhejiang Xinao Textiles' Balance Sheet?

According to the last reported balance sheet, Zhejiang Xinao Textiles had liabilities of CN¥1.83b due within 12 months, and liabilities of CN¥638.0m due beyond 12 months. On the other hand, it had cash of CN¥912.3m and CN¥790.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥764.7m.

Of course, Zhejiang Xinao Textiles has a market capitalization of CN¥4.49b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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 Xinao Textiles's net debt is only 0.99 times its EBITDA. And its EBIT covers its interest expense a whopping 34.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Zhejiang Xinao Textiles grew its EBIT at 17% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhejiang Xinao Textiles'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhejiang Xinao Textiles recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On our analysis Zhejiang Xinao Textiles's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. Considering this range of data points, we think Zhejiang Xinao Textiles is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Case in point: We've spotted 1 warning sign for Zhejiang Xinao Textiles you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.