Zhuhai CosMX Battery (SHSE:688772) 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. As with many other companies Zhuhai CosMX Battery Co., Ltd. (SHSE:688772) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhuhai CosMX Battery

What Is Zhuhai CosMX Battery's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Zhuhai CosMX Battery had CN¥6.65b of debt, an increase on CN¥5.73b, over one year. However, because it has a cash reserve of CN¥4.62b, its net debt is less, at about CN¥2.03b.

A Look At Zhuhai CosMX Battery's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhuhai CosMX Battery had liabilities of CN¥9.55b due within 12 months and liabilities of CN¥4.75b due beyond that. On the other hand, it had cash of CN¥4.62b and CN¥2.87b worth of receivables due within a year. So its liabilities total CN¥6.81b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Zhuhai CosMX Battery is worth CN¥14.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Zhuhai CosMX Battery has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 0.82 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Zhuhai CosMX Battery improved its EBIT from a last year's loss to a positive CN¥95m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhuhai CosMX Battery 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Zhuhai CosMX Battery actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Zhuhai CosMX Battery's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Zhuhai CosMX Battery's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Zhuhai CosMX Battery , and understanding them should be part of your investment process.

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.