Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Taihua New Material Co.,Ltd (SHSE:603055) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Zhejiang Taihua New MaterialLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Zhejiang Taihua New MaterialLtd had CN¥3.65b of debt, an increase on CN¥1.81b, over one year. However, it does have CN¥765.8m in cash offsetting this, leading to net debt of about CN¥2.89b.

How Healthy Is Zhejiang Taihua New MaterialLtd's Balance Sheet?

According to the last reported balance sheet, Zhejiang Taihua New MaterialLtd had liabilities of CN¥3.81b due within 12 months, and liabilities of CN¥2.30b due beyond 12 months. Offsetting this, it had CN¥765.8m in cash and CN¥1.30b in receivables that were due within 12 months. So its liabilities total CN¥4.04b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Zhejiang Taihua New MaterialLtd has a market capitalization of CN¥9.21b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhejiang Taihua New MaterialLtd's debt is 3.6 times its EBITDA, and its EBIT cover its interest expense 5.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that Zhejiang Taihua New MaterialLtd's EBIT shot up like bamboo after rain, gaining 80% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhejiang Taihua New MaterialLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhejiang Taihua New MaterialLtd saw substantial negative free cash flow, in total. 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.

Our View

Neither Zhejiang Taihua New MaterialLtd's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Zhejiang Taihua New MaterialLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Zhejiang Taihua New MaterialLtd you should be aware of, and 2 of them are potentially serious.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.