TCL Zhonghuan Renewable Energy TechnologyLtd (SZSE:002129) Seems To Be Using A Lot Of Debt

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.' 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 TCL Zhonghuan Renewable Energy Technology Co.,Ltd. (SZSE:002129) does use debt in its business. But should shareholders be worried about its use of debt?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for TCL Zhonghuan Renewable Energy TechnologyLtd

How Much Debt Does TCL Zhonghuan Renewable Energy TechnologyLtd Carry?

The image below, which you can click on for greater detail, shows that at March 2024 TCL Zhonghuan Renewable Energy TechnologyLtd had debt of CN¥40.2b, up from CN¥37.8b in one year. However, because it has a cash reserve of CN¥11.0b, its net debt is less, at about CN¥29.1b.

How Strong Is TCL Zhonghuan Renewable Energy TechnologyLtd's Balance Sheet?

We can see from the most recent balance sheet that TCL Zhonghuan Renewable Energy TechnologyLtd had liabilities of CN¥22.4b falling due within a year, and liabilities of CN¥43.2b due beyond that. On the other hand, it had cash of CN¥11.0b and CN¥10.9b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥43.7b.

Given this deficit is actually higher than the company's market capitalization of CN¥40.5b, we think shareholders really should watch TCL Zhonghuan Renewable Energy TechnologyLtd's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

With a debt to EBITDA ratio of 2.3, TCL Zhonghuan Renewable Energy TechnologyLtd uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. Shareholders should be aware that TCL Zhonghuan Renewable Energy TechnologyLtd's EBIT was down 51% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 TCL Zhonghuan Renewable Energy TechnologyLtd 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, TCL Zhonghuan Renewable Energy TechnologyLtd 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 TCL Zhonghuan Renewable Energy TechnologyLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT 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. After considering the datapoints discussed, we think TCL Zhonghuan Renewable Energy TechnologyLtd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 4 warning signs for TCL Zhonghuan Renewable Energy TechnologyLtd (of which 2 make us uncomfortable!) 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.