Is Shenzhen Kaizhong Precision Technology (SZSE:002823) Using Too Much Debt?

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.' 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. As with many other companies Shenzhen Kaizhong Precision Technology Co., Ltd. (SZSE:002823) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shenzhen Kaizhong Precision Technology

What Is Shenzhen Kaizhong Precision Technology's Net Debt?

As you can see below, Shenzhen Kaizhong Precision Technology had CN¥1.10b of debt at September 2024, down from CN¥1.66b a year prior. However, it also had CN¥103.8m in cash, and so its net debt is CN¥1.00b.

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

Zooming in on the latest balance sheet data, we can see that Shenzhen Kaizhong Precision Technology had liabilities of CN¥1.17b due within 12 months and liabilities of CN¥496.7m due beyond that. On the other hand, it had cash of CN¥103.8m and CN¥594.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥964.3m.

While this might seem like a lot, it is not so bad since Shenzhen Kaizhong Precision Technology has a market capitalization of CN¥4.66b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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 net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 3.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Shenzhen Kaizhong Precision Technology's EBIT launched higher than Elon Musk, gaining a whopping 145% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is Shenzhen Kaizhong Precision Technology's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Shenzhen Kaizhong Precision Technology produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Shenzhen Kaizhong Precision Technology's impressive EBIT growth rate implies it has the upper hand on its debt. But truth be told we feel its interest cover does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Shenzhen Kaizhong Precision Technology can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. To that end, you should be aware of the 3 warning signs we've spotted with Shenzhen Kaizhong Precision Technology .

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.