Hunan Zhongke Electric (SZSE:300035) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hunan Zhongke Electric Co., Ltd. (SZSE:300035) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hunan Zhongke Electric

What Is Hunan Zhongke Electric's Debt?

You can click the graphic below for the historical numbers, but it shows that Hunan Zhongke Electric had CN¥2.29b of debt in September 2023, down from CN¥2.97b, one year before. On the flip side, it has CN¥791.7m in cash leading to net debt of about CN¥1.50b.

How Healthy Is Hunan Zhongke Electric's Balance Sheet?

The latest balance sheet data shows that Hunan Zhongke Electric had liabilities of CN¥3.09b due within a year, and liabilities of CN¥2.33b falling due after that. On the other hand, it had cash of CN¥791.7m and CN¥2.60b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.03b.

While this might seem like a lot, it is not so bad since Hunan Zhongke Electric has a market capitalization of CN¥6.63b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.19 times and a disturbingly high net debt to EBITDA ratio of 8.8 hit our confidence in Hunan Zhongke Electric like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Hunan Zhongke Electric saw its EBIT tank 96% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hunan Zhongke Electric's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hunan Zhongke Electric saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Hunan Zhongke Electric's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Taking into account all the aforementioned factors, it looks like Hunan Zhongke Electric has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 1 warning sign for Hunan Zhongke Electric that you should be aware of before investing here.

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.