Here's Why Wuxi Zhenhua Auto PartsLtd (SHSE:605319) Can Manage Its Debt Responsibly

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.' 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. We note that Wuxi Zhenhua Auto Parts Co.,Ltd. (SHSE:605319) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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.

Check out our latest analysis for Wuxi Zhenhua Auto PartsLtd

What Is Wuxi Zhenhua Auto PartsLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Wuxi Zhenhua Auto PartsLtd had debt of CN¥826.9m, up from CN¥630.6m in one year. However, because it has a cash reserve of CN¥250.8m, its net debt is less, at about CN¥576.1m.

A Look At Wuxi Zhenhua Auto PartsLtd's Liabilities

The latest balance sheet data shows that Wuxi Zhenhua Auto PartsLtd had liabilities of CN¥2.14b due within a year, and liabilities of CN¥95.1m falling due after that. Offsetting these obligations, it had cash of CN¥250.8m as well as receivables valued at CN¥1.38b due within 12 months. So it has liabilities totalling CN¥610.9m more than its cash and near-term receivables, combined.

Of course, Wuxi Zhenhua Auto PartsLtd has a market capitalization of CN¥4.16b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Wuxi Zhenhua Auto PartsLtd has a low net debt to EBITDA ratio of only 0.93. And its EBIT easily covers its interest expense, being 19.4 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Wuxi Zhenhua Auto PartsLtd grew its EBIT by 69% over the last twelve months, and that growth will make it easier to handle its 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 Wuxi Zhenhua Auto PartsLtd 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wuxi Zhenhua Auto PartsLtd 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

Happily, Wuxi Zhenhua Auto PartsLtd's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Wuxi Zhenhua Auto PartsLtd can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Wuxi Zhenhua Auto PartsLtd 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.