Zhonghang Electronic Measuring InstrumentsLtd (SZSE:300114) Takes On Some Risk With Its Use 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Zhonghang Electronic Measuring Instruments Co.,Ltd (SZSE:300114) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Zhonghang Electronic Measuring InstrumentsLtd

What Is Zhonghang Electronic Measuring InstrumentsLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Zhonghang Electronic Measuring InstrumentsLtd had CN¥608.2m of debt, an increase on CN¥431.7m, over one year. However, it does have CN¥414.6m in cash offsetting this, leading to net debt of about CN¥193.7m.

How Strong Is Zhonghang Electronic Measuring InstrumentsLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhonghang Electronic Measuring InstrumentsLtd had liabilities of CN¥1.05b due within 12 months and liabilities of CN¥523.2m due beyond that. Offsetting these obligations, it had cash of CN¥414.6m as well as receivables valued at CN¥1.24b due within 12 months. So it actually has CN¥81.4m more liquid assets than total liabilities.

Having regard to Zhonghang Electronic Measuring InstrumentsLtd's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥23.4b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Zhonghang Electronic Measuring InstrumentsLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

We'd say that Zhonghang Electronic Measuring InstrumentsLtd's moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Zhonghang Electronic Measuring InstrumentsLtd's EBIT fell a jaw-dropping 72% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Zhonghang Electronic Measuring InstrumentsLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Zhonghang Electronic Measuring InstrumentsLtd 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

Zhonghang Electronic Measuring InstrumentsLtd's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Zhonghang Electronic Measuring InstrumentsLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. We've identified 2 warning signs with Zhonghang Electronic Measuring InstrumentsLtd (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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.