Zhejiang RIFA Precision Machinery (SZSE:002520) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Zhejiang RIFA Precision Machinery Co., Ltd. (SZSE:002520) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Zhejiang RIFA Precision Machinery

How Much Debt Does Zhejiang RIFA Precision Machinery Carry?

As you can see below, Zhejiang RIFA Precision Machinery had CN¥1.42b of debt at September 2024, down from CN¥1.60b a year prior. However, it also had CN¥292.7m in cash, and so its net debt is CN¥1.13b.

How Healthy Is Zhejiang RIFA Precision Machinery's Balance Sheet?

We can see from the most recent balance sheet that Zhejiang RIFA Precision Machinery had liabilities of CN¥2.61b falling due within a year, and liabilities of CN¥162.6m due beyond that. Offsetting these obligations, it had cash of CN¥292.7m as well as receivables valued at CN¥490.0m due within 12 months. So it has liabilities totalling CN¥1.99b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Zhejiang RIFA Precision Machinery has a market capitalization of CN¥4.70b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Zhejiang RIFA Precision Machinery's net debt to EBITDA ratio of 4.8, we think its super-low interest cover of 0.023 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Zhejiang RIFA Precision Machinery achieved a positive EBIT of CN¥1.4m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zhejiang RIFA Precision Machinery 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Zhejiang RIFA Precision Machinery actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Zhejiang RIFA Precision Machinery's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that Zhejiang RIFA Precision Machinery's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 - Zhejiang RIFA Precision Machinery has 2 warning signs we think you should be aware of.

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.