Is Zhejiang Chang'an Renheng Technology (HKG:8139) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Zhejiang Chang'an Renheng Technology Co., Ltd. (HKG:8139) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Zhejiang Chang'an Renheng Technology

What Is Zhejiang Chang'an Renheng Technology's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 Zhejiang Chang'an Renheng Technology had CN¥93.6m of debt, an increase on CN¥87.7m, over one year. However, it also had CN¥8.69m in cash, and so its net debt is CN¥84.9m.

How Strong Is Zhejiang Chang'an Renheng Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Chang'an Renheng Technology had liabilities of CN¥132.9m due within 12 months and liabilities of CN¥1.94m due beyond that. Offsetting this, it had CN¥8.69m in cash and CN¥66.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥59.8m.

Given this deficit is actually higher than the company's market capitalization of CN¥42.7m, we think shareholders really should watch Zhejiang Chang'an Renheng Technology'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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

While we wouldn't worry about Zhejiang Chang'an Renheng Technology's net debt to EBITDA ratio of 3.3, we think its super-low interest cover of 2.5 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Looking on the bright side, Zhejiang Chang'an Renheng Technology boosted its EBIT by a silky 86% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is Zhejiang Chang'an Renheng Technology's earnings that will influence how the balance sheet holds up in the future. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zhejiang Chang'an Renheng Technology recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Zhejiang Chang'an Renheng Technology's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Zhejiang Chang'an Renheng Technology's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 instance, we've identified 3 warning signs for Zhejiang Chang'an Renheng Technology (2 are concerning) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.