These 4 Measures Indicate That Shanghai Zhenhua Heavy Industries (SHSE:600320) Is Using Debt Extensively

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.' 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. Importantly, Shanghai Zhenhua Heavy Industries Co., Ltd. (SHSE:600320) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shanghai Zhenhua Heavy Industries

What Is Shanghai Zhenhua Heavy Industries's Net Debt?

As you can see below, Shanghai Zhenhua Heavy Industries had CN¥31.2b of debt at September 2023, down from CN¥32.8b a year prior. However, because it has a cash reserve of CN¥4.78b, its net debt is less, at about CN¥26.4b.

How Healthy Is Shanghai Zhenhua Heavy Industries' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Zhenhua Heavy Industries had liabilities of CN¥48.0b due within 12 months and liabilities of CN¥17.9b due beyond that. Offsetting these obligations, it had cash of CN¥4.78b as well as receivables valued at CN¥12.8b due within 12 months. So it has liabilities totalling CN¥48.3b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥13.6b 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. After all, Shanghai Zhenhua Heavy Industries would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Shanghai Zhenhua Heavy Industries has a rather high debt to EBITDA ratio of 9.4 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.8 times, suggesting it can responsibly service its obligations. The silver lining is that Shanghai Zhenhua Heavy Industries grew its EBIT by 317% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Shanghai Zhenhua Heavy Industries 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Shanghai Zhenhua Heavy Industries actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We feel some trepidation about Shanghai Zhenhua Heavy Industries's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Shanghai Zhenhua Heavy Industries is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example Shanghai Zhenhua Heavy Industries has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.