Wuchan Zhongda GroupLtd (SHSE:600704) Has A Somewhat Strained Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Wuchan Zhongda Group Co.,Ltd. (SHSE:600704) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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 Wuchan Zhongda GroupLtd

What Is Wuchan Zhongda GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Wuchan Zhongda GroupLtd had debt of CN¥54.0b, up from CN¥37.3b in one year. On the flip side, it has CN¥29.8b in cash leading to net debt of about CN¥24.2b.

A Look At Wuchan Zhongda GroupLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Wuchan Zhongda GroupLtd had liabilities of CN¥133.3b due within 12 months and liabilities of CN¥17.6b due beyond that. Offsetting these obligations, it had cash of CN¥29.8b as well as receivables valued at CN¥20.4b due within 12 months. So it has liabilities totalling CN¥100.8b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥25.3b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Wuchan Zhongda GroupLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Wuchan Zhongda GroupLtd's net debt is 3.4 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We saw Wuchan Zhongda GroupLtd grow its EBIT by 4.3% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Wuchan Zhongda GroupLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Wuchan Zhongda GroupLtd 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

To be frank both Wuchan Zhongda GroupLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Wuchan Zhongda GroupLtd 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. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Wuchan Zhongda GroupLtd (of which 2 are significant!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.