Is Hunan Zhongke Electric (SZSE:300035) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Hunan Zhongke Electric Co., Ltd. (SZSE:300035) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View 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 as of September 2024 Hunan Zhongke Electric had CN¥2.93b of debt, an increase on CN¥2.29b, over one year. However, it also had CN¥834.1m in cash, and so its net debt is CN¥2.09b.

How Strong Is Hunan Zhongke Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hunan Zhongke Electric had liabilities of CN¥4.33b due within 12 months and liabilities of CN¥1.96b due beyond that. Offsetting these obligations, it had cash of CN¥834.1m as well as receivables valued at CN¥2.77b due within 12 months. So it has liabilities totalling CN¥2.68b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Hunan Zhongke Electric is worth CN¥9.88b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Hunan Zhongke Electric has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that Hunan Zhongke Electric actually grew its EBIT by a hefty 889%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hunan Zhongke Electric can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Hunan Zhongke Electric burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Hunan Zhongke Electric's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Hunan Zhongke Electric's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Hunan Zhongke Electric has 3 warning signs (and 1 which can't be ignored) we think you should know about.

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.