The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Chongqing Zongshen Power Machinery Co.,Ltd (SZSE:001696) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Chongqing Zongshen Power MachineryLtd Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Chongqing Zongshen Power MachineryLtd had debt of CN¥2.38b, up from CN¥1.55b in one year. On the flip side, it has CN¥1.78b in cash leading to net debt of about CN¥596.4m.

How Strong Is Chongqing Zongshen Power MachineryLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chongqing Zongshen Power MachineryLtd had liabilities of CN¥2.88b due within 12 months and liabilities of CN¥3.05b due beyond that. Offsetting these obligations, it had cash of CN¥1.78b as well as receivables valued at CN¥2.98b due within 12 months. So it has liabilities totalling CN¥1.17b more than its cash and near-term receivables, combined.

Given Chongqing Zongshen Power MachineryLtd has a market capitalization of CN¥15.8b, it's hard to believe these liabilities pose much threat. 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).

With net debt sitting at just 0.90 times EBITDA, Chongqing Zongshen Power MachineryLtd is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.3 times the interest expense over the last year. Another good sign is that Chongqing Zongshen Power MachineryLtd has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. 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 Chongqing Zongshen Power MachineryLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Chongqing Zongshen Power MachineryLtd recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Chongqing Zongshen Power MachineryLtd's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that Chongqing Zongshen Power MachineryLtd is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Chongqing Zongshen Power MachineryLtd that you should be aware of.

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.