Zhou Hei Ya International Holdings (HKG:1458) Could Easily Take On More 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. As with many other companies Zhou Hei Ya International Holdings Company Limited (HKG:1458) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Zhou Hei Ya International Holdings

How Much Debt Does Zhou Hei Ya International Holdings Carry?

As you can see below, Zhou Hei Ya International Holdings had CN¥370.6m of debt at June 2023, down from CN¥1.48b a year prior. But on the other hand it also has CN¥2.19b in cash, leading to a CN¥1.82b net cash position.

A Look At Zhou Hei Ya International Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Zhou Hei Ya International Holdings had liabilities of CN¥830.5m due within 12 months and liabilities of CN¥446.1m due beyond that. On the other hand, it had cash of CN¥2.19b and CN¥66.2m worth of receivables due within a year. So it actually has CN¥978.2m more liquid assets than total liabilities.

This surplus suggests that Zhou Hei Ya International Holdings is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Zhou Hei Ya International Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Zhou Hei Ya International Holdings grew its EBIT by 115% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Zhou Hei Ya International Holdings 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. While Zhou Hei Ya International Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Zhou Hei Ya International Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case Zhou Hei Ya International Holdings has CN¥1.82b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥307m, being 235% of its EBIT. The bottom line is that we do not find Zhou Hei Ya International Holdings's debt levels at all concerning. 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. We've identified 2 warning signs with Zhou Hei Ya International Holdings (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.