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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Zhejiang XCC Group Co.,Ltd (SHSE:603667) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Zhejiang XCC GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Zhejiang XCC GroupLtd had debt of CN¥1.08b, up from CN¥832.2m in one year. However, it also had CN¥670.9m in cash, and so its net debt is CN¥404.4m.

How Strong Is Zhejiang XCC GroupLtd's Balance Sheet?

The latest balance sheet data shows that Zhejiang XCC GroupLtd had liabilities of CN¥1.89b due within a year, and liabilities of CN¥206.2m falling due after that. Offsetting these obligations, it had cash of CN¥670.9m as well as receivables valued at CN¥1.07b due within 12 months. So it has liabilities totalling CN¥347.3m more than its cash and near-term receivables, combined.

Since publicly traded Zhejiang XCC GroupLtd shares are worth a total of CN¥10.4b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Zhejiang XCC GroupLtd's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.6 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly Zhejiang XCC GroupLtd's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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 Zhejiang XCC GroupLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhejiang XCC GroupLtd reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Zhejiang XCC GroupLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its level of total liabilities was a positive. Looking at all this data makes us feel a little cautious about Zhejiang XCC GroupLtd's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 example Zhejiang XCC GroupLtd has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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.