David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Zhejiang RIFA Precision Machinery Co., Ltd. (SZSE:002520) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Zhejiang RIFA Precision Machinery's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Zhejiang RIFA Precision Machinery had CN¥1.40b of debt in June 2024, down from CN¥1.62b, one year before. However, it does have CN¥291.5m in cash offsetting this, leading to net debt of about CN¥1.11b.

How Strong Is Zhejiang RIFA Precision Machinery's Balance Sheet?

The latest balance sheet data shows that Zhejiang RIFA Precision Machinery had liabilities of CN¥2.47b due within a year, and liabilities of CN¥272.6m falling due after that. Offsetting these obligations, it had cash of CN¥291.5m as well as receivables valued at CN¥484.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.97b.

This deficit isn't so bad because Zhejiang RIFA Precision Machinery is worth CN¥3.93b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

While we wouldn't worry about Zhejiang RIFA Precision Machinery's net debt to EBITDA ratio of 3.8, we think its super-low interest cover of 0.87 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that Zhejiang RIFA Precision Machinery actually grew its EBIT by a hefty 310%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhejiang RIFA Precision Machinery will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Zhejiang RIFA Precision Machinery actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Zhejiang RIFA Precision Machinery's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the elements mentioned above, it seems to us that Zhejiang RIFA Precision Machinery is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Case in point: We've spotted 2 warning signs for Zhejiang RIFA Precision Machinery you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.