David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Zhejiang Chang'an Renheng Technology Co., Ltd. (HKG:8139) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Zhejiang Chang'an Renheng Technology's Debt?
The image below, which you can click on for greater detail, shows that at December 2018 Zhejiang Chang'an Renheng Technology had debt of CN¥75.5m, up from CN¥65.1m in one year. However, it does have CN¥23.0m in cash offsetting this, leading to net debt of about CN¥52.5m.
How Healthy Is Zhejiang Chang'an Renheng Technology's Balance Sheet?
We can see from the most recent balance sheet that Zhejiang Chang'an Renheng Technology had liabilities of CN¥83.9m falling due within a year, and liabilities of CN¥23.7m due beyond that. Offsetting these obligations, it had cash of CN¥23.0m as well as receivables valued at CN¥44.0m due within 12 months. So its liabilities total CN¥40.6m more than the combination of its cash and short-term receivables.
Since publicly traded Zhejiang Chang'an Renheng Technology shares are worth a total of CN¥439.9m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Zhejiang Chang'an Renheng Technology's debt to EBITDA ratio (2.9) suggests that it uses debt fairly modestly, its interest cover is very weak, at 1.5. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Zhejiang Chang'an Renheng Technology grew its EBIT by 1088% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Zhejiang Chang'an Renheng Technology 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Zhejiang Chang'an Renheng Technology 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.
Zhejiang Chang'an Renheng Technology's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Zhejiang Chang'an Renheng Technology's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Zhejiang Chang'an Renheng Technology's earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.