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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Zenner Metering Technology (Shanghai) Ltd. (SZSE:301303) does use debt in its business. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zenner Metering Technology (Shanghai)'s Debt?

As you can see below, at the end of September 2024, Zenner Metering Technology (Shanghai) had CN¥324.7m of debt, up from CN¥36.0m a year ago. Click the image for more detail. However, it does have CN¥570.0m in cash offsetting this, leading to net cash of CN¥245.3m.

How Healthy Is Zenner Metering Technology (Shanghai)'s Balance Sheet?

According to the last reported balance sheet, Zenner Metering Technology (Shanghai) had liabilities of CN¥807.2m due within 12 months, and liabilities of CN¥30.4m due beyond 12 months. On the other hand, it had cash of CN¥570.0m and CN¥1.23b worth of receivables due within a year. So it can boast CN¥957.9m more liquid assets than total liabilities.

This short term liquidity is a sign that Zenner Metering Technology (Shanghai) could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Zenner Metering Technology (Shanghai) has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that Zenner Metering Technology (Shanghai) saw its EBIT decline by 5.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zenner Metering Technology (Shanghai) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Zenner Metering Technology (Shanghai) may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Zenner Metering Technology (Shanghai) 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.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Zenner Metering Technology (Shanghai) has net cash of CN¥245.3m, as well as more liquid assets than liabilities. So we are not troubled with Zenner Metering Technology (Shanghai)'s debt use. 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. We've identified 2 warning signs with Zenner Metering Technology (Shanghai) , and understanding them should be part of your investment process.

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.