Zhejiang XCC GroupLtd (SHSE:603667) Takes On Some Risk With Its Use Of Debt
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 can see that Zhejiang XCC Group Co.,Ltd (SHSE:603667) does use debt in its business. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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What Is Zhejiang XCC GroupLtd's Debt?
The image below, which you can click on for greater detail, shows that Zhejiang XCC GroupLtd had debt of CN¥832.2m at the end of September 2023, a reduction from CN¥1.15b over a year. On the flip side, it has CN¥695.1m in cash leading to net debt of about CN¥137.1m.
How Strong Is Zhejiang XCC GroupLtd's Balance Sheet?
We can see from the most recent balance sheet that Zhejiang XCC GroupLtd had liabilities of CN¥1.53b falling due within a year, and liabilities of CN¥276.8m due beyond that. On the other hand, it had cash of CN¥695.1m and CN¥1.12b worth of receivables due within a year. So these liquid assets roughly match the total liabilities.
Having regard to Zhejiang XCC GroupLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥6.62b company is short on cash, but still worth keeping an eye on the balance sheet.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Zhejiang XCC GroupLtd's net debt is only 0.58 times its EBITDA. And its EBIT easily covers its interest expense, being 11.7 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Zhejiang XCC GroupLtd if management cannot prevent a repeat of the 46% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Zhejiang XCC GroupLtd 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Zhejiang XCC GroupLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Both Zhejiang XCC GroupLtd's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But on the brighter side of life, its interest cover leaves us feeling more frolicsome. Taking the abovementioned factors together we do think Zhejiang XCC GroupLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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, we've discovered 4 warning signs for Zhejiang XCC GroupLtd that you should be aware of before investing here.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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About SHSE:603667
Zhejiang XCC GroupLtd
Engages in the research, development, manufacture, and sale of bearings in the United States, Japan, Korea, Brazil, and internationally.
Excellent balance sheet with reasonable growth potential.