We Think Zhejiang Tiancheng Controls (SHSE:603085) Is Taking Some Risk With Its Debt

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. As with many other companies Zhejiang Tiancheng Controls Co., Ltd. (SHSE:603085) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Zhejiang Tiancheng Controls

What Is Zhejiang Tiancheng Controls's Debt?

As you can see below, at the end of September 2024, Zhejiang Tiancheng Controls had CN¥805.7m of debt, up from CN¥553.9m a year ago. Click the image for more detail. However, it does have CN¥257.9m in cash offsetting this, leading to net debt of about CN¥547.9m.

How Healthy Is Zhejiang Tiancheng Controls' Balance Sheet?

We can see from the most recent balance sheet that Zhejiang Tiancheng Controls had liabilities of CN¥1.72b falling due within a year, and liabilities of CN¥538.6m due beyond that. Offsetting these obligations, it had cash of CN¥257.9m as well as receivables valued at CN¥757.9m due within 12 months. So its liabilities total CN¥1.24b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Zhejiang Tiancheng Controls has a market capitalization of CN¥3.84b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

While Zhejiang Tiancheng Controls's debt to EBITDA ratio (4.6) suggests that it uses some debt, its interest cover is very weak, at 0.57, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for Zhejiang Tiancheng Controls is that it turned last year's EBIT loss into a gain of CN¥11m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Zhejiang Tiancheng Controls's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Zhejiang Tiancheng Controls 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.

Our View

To be frank both Zhejiang Tiancheng Controls's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that Zhejiang Tiancheng Controls's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Zhejiang Tiancheng Controls you should know about.

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.