Chongqing Zongshen Power MachineryLtd (SZSE:001696) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Chongqing Zongshen Power Machinery Co.,Ltd (SZSE:001696) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Chongqing Zongshen Power MachineryLtd

How Much Debt Does Chongqing Zongshen Power MachineryLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Chongqing Zongshen Power MachineryLtd had CN¥1.35b of debt, an increase on CN¥1.22b, over one year. But it also has CN¥1.76b in cash to offset that, meaning it has CN¥416.8m net cash.

A Look At Chongqing Zongshen Power MachineryLtd's Liabilities

The latest balance sheet data shows that Chongqing Zongshen Power MachineryLtd had liabilities of CN¥2.64b due within a year, and liabilities of CN¥1.74b falling due after that. Offsetting these obligations, it had cash of CN¥1.76b as well as receivables valued at CN¥2.18b due within 12 months. So it has liabilities totalling CN¥436.0m more than its cash and near-term receivables, combined.

Given Chongqing Zongshen Power MachineryLtd has a market capitalization of CN¥9.30b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Chongqing Zongshen Power MachineryLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Chongqing Zongshen Power MachineryLtd's saving grace is its low debt levels, because its EBIT has tanked 26% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Chongqing Zongshen Power MachineryLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Chongqing Zongshen Power MachineryLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Chongqing Zongshen Power MachineryLtd actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Chongqing Zongshen Power MachineryLtd has CN¥416.8m in net cash. The cherry on top was that in converted 100% of that EBIT to free cash flow, bringing in CN¥148m. So we don't have any problem with Chongqing Zongshen Power MachineryLtd's use of 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. For example - Chongqing Zongshen Power MachineryLtd has 1 warning sign we think 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.