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.' 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. Importantly, ZheJiang KangLongDa Special Protection Technology Co., Ltd (SHSE:603665) does carry debt. But is this debt a concern to shareholders?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for ZheJiang KangLongDa Special Protection Technology
What Is ZheJiang KangLongDa Special Protection Technology's Net Debt?
You can click the graphic below for the historical numbers, but it shows that ZheJiang KangLongDa Special Protection Technology had CN¥1.21b of debt in September 2023, down from CN¥1.46b, one year before. On the flip side, it has CN¥203.8m in cash leading to net debt of about CN¥1.01b.
How Strong Is ZheJiang KangLongDa Special Protection Technology's Balance Sheet?
The latest balance sheet data shows that ZheJiang KangLongDa Special Protection Technology had liabilities of CN¥1.58b due within a year, and liabilities of CN¥443.9m falling due after that. Offsetting this, it had CN¥203.8m in cash and CN¥208.5m in receivables that were due within 12 months. So its liabilities total CN¥1.61b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because ZheJiang KangLongDa Special Protection Technology is worth CN¥4.22b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
As it happens ZheJiang KangLongDa Special Protection Technology has a fairly concerning net debt to EBITDA ratio of 6.2 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably, ZheJiang KangLongDa Special Protection Technology made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥100m in the last twelve months. 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 KangLongDa Special Protection 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Considering the last year, ZheJiang KangLongDa Special Protection Technology actually recorded a cash outflow, overall. 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
ZheJiang KangLongDa Special Protection Technology's net debt to EBITDA and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think ZheJiang KangLongDa Special Protection Technology'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example ZheJiang KangLongDa Special Protection Technology has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.
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.