Here's Why Shenzhen Kaizhong Precision Technology (SZSE:002823) Can Manage Its Debt Responsibly

Warren Buffett famously said, '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. Importantly, Shenzhen Kaizhong Precision Technology Co., Ltd. (SZSE:002823) does carry debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shenzhen Kaizhong Precision Technology

What Is Shenzhen Kaizhong Precision Technology's Net Debt?

The image below, which you can click on for greater detail, shows that Shenzhen Kaizhong Precision Technology had debt of CN¥1.48b at the end of June 2024, a reduction from CN¥1.77b over a year. However, it also had CN¥107.8m in cash, and so its net debt is CN¥1.37b.

How Strong Is Shenzhen Kaizhong Precision Technology's Balance Sheet?

The latest balance sheet data shows that Shenzhen Kaizhong Precision Technology had liabilities of CN¥1.56b due within a year, and liabilities of CN¥510.5m falling due after that. Offsetting these obligations, it had cash of CN¥107.8m as well as receivables valued at CN¥594.5m due within 12 months. So it has liabilities totalling CN¥1.37b more than its cash and near-term receivables, combined.

Shenzhen Kaizhong Precision Technology has a market capitalization of CN¥4.31b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Shenzhen Kaizhong Precision Technology's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 7.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Shenzhen Kaizhong Precision Technology's EBIT launched higher than Elon Musk, gaining a whopping 368% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shenzhen Kaizhong Precision Technology 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Shenzhen Kaizhong Precision Technology's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Shenzhen Kaizhong Precision Technology was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Shenzhen Kaizhong Precision Technology is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 instance, we've identified 4 warning signs for Shenzhen Kaizhong Precision Technology (3 are a bit concerning) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.