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

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.' 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. We note that Hunan Zhongke Electric Co., Ltd. (SZSE:300035) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hunan Zhongke Electric

What Is Hunan Zhongke Electric's Debt?

The image below, which you can click on for greater detail, shows that Hunan Zhongke Electric had debt of CN¥2.69b at the end of March 2024, a reduction from CN¥3.69b over a year. However, it does have CN¥951.9m in cash offsetting this, leading to net debt of about CN¥1.74b.

A Look At Hunan Zhongke Electric's Liabilities

Zooming in on the latest balance sheet data, we can see that Hunan Zhongke Electric had liabilities of CN¥3.51b due within 12 months and liabilities of CN¥2.14b due beyond that. On the other hand, it had cash of CN¥951.9m and CN¥2.53b worth of receivables due within a year. So it has liabilities totalling CN¥2.17b more than its cash and near-term receivables, combined.

Hunan Zhongke Electric has a market capitalization of CN¥5.94b, 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.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Hunan Zhongke Electric's debt to EBITDA ratio (3.5) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that Hunan Zhongke Electric saw its EBIT drop by 18% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Hunan Zhongke Electric can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hunan Zhongke Electric saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Hunan Zhongke Electric's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. We're quite clear that we consider Hunan Zhongke Electric to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Hunan Zhongke Electric you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.

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