Is ZHEJIANG NARADA POWER SOURCE (SZSE:300068) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that ZHEJIANG NARADA POWER SOURCE Co. , Ltd. (SZSE:300068) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. 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.

See our latest analysis for ZHEJIANG NARADA POWER SOURCE

What Is ZHEJIANG NARADA POWER SOURCE's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 ZHEJIANG NARADA POWER SOURCE had CN¥6.13b of debt, an increase on CN¥4.63b, over one year. On the flip side, it has CN¥2.79b in cash leading to net debt of about CN¥3.34b.

How Strong Is ZHEJIANG NARADA POWER SOURCE's Balance Sheet?

The latest balance sheet data shows that ZHEJIANG NARADA POWER SOURCE had liabilities of CN¥10.6b due within a year, and liabilities of CN¥3.20b falling due after that. Offsetting this, it had CN¥2.79b in cash and CN¥3.66b in receivables that were due within 12 months. So it has liabilities totalling CN¥7.32b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥10.4b, so it does suggest shareholders should keep an eye on ZHEJIANG NARADA POWER SOURCE's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about ZHEJIANG NARADA POWER SOURCE's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 2.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, the silver lining was that ZHEJIANG NARADA POWER SOURCE achieved a positive EBIT of CN¥560m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if ZHEJIANG NARADA POWER SOURCE 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, ZHEJIANG NARADA POWER SOURCE burned a lot of cash. 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 ZHEJIANG NARADA POWER SOURCE's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Overall, it seems to us that ZHEJIANG NARADA POWER SOURCE's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that ZHEJIANG NARADA POWER SOURCE is showing 2 warning signs in our investment analysis , 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.