Is Zhe Jiang Hai Liang (SZSE:002203) 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. Importantly, Zhe Jiang Hai Liang Co., Ltd (SZSE:002203) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Zhe Jiang Hai Liang

How Much Debt Does Zhe Jiang Hai Liang Carry?

As you can see below, at the end of September 2024, Zhe Jiang Hai Liang had CN¥22.8b of debt, up from CN¥19.3b a year ago. Click the image for more detail. However, it also had CN¥6.07b in cash, and so its net debt is CN¥16.8b.

How Healthy Is Zhe Jiang Hai Liang's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhe Jiang Hai Liang had liabilities of CN¥18.7b due within 12 months and liabilities of CN¥9.17b due beyond that. On the other hand, it had cash of CN¥6.07b and CN¥9.90b worth of receivables due within a year. So it has liabilities totalling CN¥11.9b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥19.1b. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 9.8, it's fair to say Zhe Jiang Hai Liang does have a significant amount of debt. However, its interest coverage of 3.5 is reasonably strong, which is a good sign. Worse, Zhe Jiang Hai Liang's EBIT was down 37% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Zhe Jiang Hai Liang 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhe Jiang Hai Liang 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, Zhe Jiang Hai Liang's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Zhe Jiang Hai Liang 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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Zhe Jiang Hai Liang (1 is significant!) 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.