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.' 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. As with many other companies JiangSu Zhenjiang New Energy Equipment Co., Ltd. (SHSE:603507) makes use of debt. 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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is JiangSu Zhenjiang New Energy Equipment's Debt?

The chart below, which you can click on for greater detail, shows that JiangSu Zhenjiang New Energy Equipment had CN¥1.30b in debt in June 2024; about the same as the year before. However, it also had CN¥663.4m in cash, and so its net debt is CN¥632.4m.

How Strong Is JiangSu Zhenjiang New Energy Equipment's Balance Sheet?

We can see from the most recent balance sheet that JiangSu Zhenjiang New Energy Equipment had liabilities of CN¥2.88b falling due within a year, and liabilities of CN¥859.0m due beyond that. Offsetting these obligations, it had cash of CN¥663.4m as well as receivables valued at CN¥976.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.10b.

While this might seem like a lot, it is not so bad since JiangSu Zhenjiang New Energy Equipment has a market capitalization of CN¥4.18b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.0 and interest cover of 2.5 times, it seems to us that JiangSu Zhenjiang New Energy Equipment is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that JiangSu Zhenjiang New Energy Equipment's EBIT shot up like bamboo after rain, gaining 47% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if JiangSu Zhenjiang New Energy Equipment can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, JiangSu Zhenjiang New Energy Equipment 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 JiangSu Zhenjiang New Energy Equipment's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that JiangSu Zhenjiang New Energy Equipment's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example - JiangSu Zhenjiang New Energy Equipment 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.