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. Importantly, Zhonglu.Co.,Ltd (SHSE:600818) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Zhonglu.Co.Ltd's Net Debt?
The image below, which you can click on for greater detail, shows that Zhonglu.Co.Ltd had debt of CN¥35.1m at the end of September 2023, a reduction from CN¥54.1m over a year. But on the other hand it also has CN¥227.5m in cash, leading to a CN¥192.4m net cash position.
How Strong Is Zhonglu.Co.Ltd's Balance Sheet?
According to the last reported balance sheet, Zhonglu.Co.Ltd had liabilities of CN¥232.1m due within 12 months, and liabilities of CN¥146.8m due beyond 12 months. Offsetting these obligations, it had cash of CN¥227.5m as well as receivables valued at CN¥137.8m due within 12 months. So its liabilities total CN¥13.6m more than the combination of its cash and short-term receivables.
This state of affairs indicates that Zhonglu.Co.Ltd's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥3.75b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Zhonglu.Co.Ltd boasts net cash, so it's fair to say it does not have a heavy debt load!
It was also good to see that despite losing money on the EBIT line last year, Zhonglu.Co.Ltd turned things around in the last 12 months, delivering and EBIT of CN¥5.7m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhonglu.Co.Ltd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Zhonglu.Co.Ltd may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Zhonglu.Co.Ltd 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.
Summing Up
We could understand if investors are concerned about Zhonglu.Co.Ltd's liabilities, but we can be reassured by the fact it has has net cash of CN¥192.4m. So we don't have any problem with Zhonglu.Co.Ltd's use of debt. 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. We've identified 2 warning signs with Zhonglu.Co.Ltd , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.