Is Hangzhou Zhongheng Electric (SZSE:002364) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Hangzhou Zhongheng Electric Co., Ltd (SZSE:002364) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hangzhou Zhongheng Electric

How Much Debt Does Hangzhou Zhongheng Electric Carry?

The image below, which you can click on for greater detail, shows that at June 2024 Hangzhou Zhongheng Electric had debt of CN¥100.3m, up from CN¥40.0m in one year. But on the other hand it also has CN¥767.2m in cash, leading to a CN¥666.9m net cash position.

How Healthy Is Hangzhou Zhongheng Electric's Balance Sheet?

We can see from the most recent balance sheet that Hangzhou Zhongheng Electric had liabilities of CN¥996.6m falling due within a year, and liabilities of CN¥10.1m due beyond that. Offsetting these obligations, it had cash of CN¥767.2m as well as receivables valued at CN¥966.7m due within 12 months. So it actually has CN¥727.2m more liquid assets than total liabilities.

It's good to see that Hangzhou Zhongheng Electric has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, Hangzhou Zhongheng Electric boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, Hangzhou Zhongheng Electric turned things around in the last 12 months, delivering and EBIT of CN¥24m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hangzhou Zhongheng Electric will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Hangzhou Zhongheng Electric has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Hangzhou Zhongheng Electric 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.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hangzhou Zhongheng Electric has CN¥666.9m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 1,262% of that EBIT to free cash flow, bringing in CN¥298m. So is Hangzhou Zhongheng Electric'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. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Hangzhou Zhongheng Electric you should be aware of, and 1 of them can't be ignored.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.