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.' 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. We can see that Shanghai Zhenhua Heavy Industries Co., Ltd. (SHSE:600320) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Shanghai Zhenhua Heavy Industries Carry?

You can click the graphic below for the historical numbers, but it shows that Shanghai Zhenhua Heavy Industries had CN¥28.1b of debt in June 2024, down from CN¥31.7b, one year before. However, it also had CN¥6.26b in cash, and so its net debt is CN¥21.9b.

How Strong Is Shanghai Zhenhua Heavy Industries' Balance Sheet?

According to the last reported balance sheet, Shanghai Zhenhua Heavy Industries had liabilities of CN¥42.9b due within 12 months, and liabilities of CN¥22.6b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.26b as well as receivables valued at CN¥12.5b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥46.7b.

The deficiency here weighs heavily on the CN¥16.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Shanghai Zhenhua Heavy Industries would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shanghai Zhenhua Heavy Industries shareholders face the double whammy of a high net debt to EBITDA ratio (8.9), and fairly weak interest coverage, since EBIT is just 2.5 times the interest expense. The debt burden here is substantial. More concerning, Shanghai Zhenhua Heavy Industries saw its EBIT drop by 5.8% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off 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 Shanghai Zhenhua Heavy Industries 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shanghai Zhenhua Heavy Industries actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Shanghai Zhenhua Heavy Industries's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Shanghai Zhenhua Heavy Industries's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 3 warning signs for Shanghai Zhenhua Heavy Industries (1 doesn't sit too well with us) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.