Here's Why Shanghai Zhenhua Heavy Industries (SHSE:600320) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Shanghai Zhenhua Heavy Industries Co., Ltd. (SHSE:600320) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shanghai Zhenhua Heavy Industries

What Is Shanghai Zhenhua Heavy Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shanghai Zhenhua Heavy Industries had CN¥28.1b of debt in March 2024, down from CN¥32.7b, one year before. However, because it has a cash reserve of CN¥5.22b, its net debt is less, at about CN¥22.8b.

How Strong Is Shanghai Zhenhua Heavy Industries' Balance Sheet?

According to the last reported balance sheet, Shanghai Zhenhua Heavy Industries had liabilities of CN¥45.1b due within 12 months, and liabilities of CN¥20.5b due beyond 12 months. Offsetting these obligations, it had cash of CN¥5.22b as well as receivables valued at CN¥12.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥47.4b.

The deficiency here weighs heavily on the CN¥14.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Shanghai Zhenhua Heavy Industries would probably need a major re-capitalization if its creditors were to demand repayment.

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.

With a net debt to EBITDA ratio of 9.1, it's fair to say Shanghai Zhenhua Heavy Industries does have a significant amount of debt. However, its interest coverage of 2.7 is reasonably strong, which is a good sign. Even more troubling is the fact that Shanghai Zhenhua Heavy Industries actually let its EBIT decrease by 6.3% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Zhenhua Heavy Industries'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shanghai Zhenhua Heavy Industries 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.

Our View

On the face of it, Shanghai Zhenhua Heavy Industries's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Shanghai Zhenhua Heavy Industries's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Zhenhua Heavy Industries (of which 1 is a bit concerning!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com