Is Chongqing Zongshen Power MachineryLtd (SZSE:001696) Using Too Much Debt?

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. We note that Chongqing Zongshen Power Machinery Co.,Ltd (SZSE:001696) 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 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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

What Is Chongqing Zongshen Power MachineryLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Chongqing Zongshen Power MachineryLtd had debt of CN¥2.21b, up from CN¥1.26b in one year. However, its balance sheet shows it holds CN¥2.41b in cash, so it actually has CN¥200.6m net cash.

How Strong Is Chongqing Zongshen Power MachineryLtd's Balance Sheet?

According to the last reported balance sheet, Chongqing Zongshen Power MachineryLtd had liabilities of CN¥2.72b due within 12 months, and liabilities of CN¥2.96b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.41b as well as receivables valued at CN¥2.79b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥483.7m.

Given Chongqing Zongshen Power MachineryLtd has a market capitalization of CN¥11.3b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. 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.

Also positive, Chongqing Zongshen Power MachineryLtd grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chongqing Zongshen Power MachineryLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Chongqing Zongshen Power MachineryLtd 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, Chongqing Zongshen Power MachineryLtd generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

We could understand if investors are concerned about Chongqing Zongshen Power MachineryLtd's liabilities, but we can be reassured by the fact it has has net cash of CN¥200.6m. And it impressed us with free cash flow of CN¥68m, being 82% of its EBIT. So is Chongqing Zongshen Power MachineryLtd's debt a risk? It doesn't seem so to us. 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. Be aware that Chongqing Zongshen Power MachineryLtd is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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