Jiangsu Rongtai Industry (SHSE:605133) Seems To Use Debt Quite Sensibly

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.' 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. Importantly, Jiangsu Rongtai Industry Co., Ltd. (SHSE:605133) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Jiangsu Rongtai Industry

How Much Debt Does Jiangsu Rongtai Industry Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Jiangsu Rongtai Industry had debt of CN¥855.4m, up from CN¥572.9m in one year. However, it does have CN¥348.2m in cash offsetting this, leading to net debt of about CN¥507.3m.

How Healthy Is Jiangsu Rongtai Industry's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Jiangsu Rongtai Industry had liabilities of CN¥1.70b due within 12 months and liabilities of CN¥85.0m due beyond that. Offsetting this, it had CN¥348.2m in cash and CN¥885.0m in receivables that were due within 12 months. So its liabilities total CN¥554.2m more than the combination of its cash and short-term receivables.

Given Jiangsu Rongtai Industry has a market capitalization of CN¥4.48b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Jiangsu Rongtai Industry's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 20.2 times over. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Jiangsu Rongtai Industry has been able to increase its EBIT by 21% in twelve months, making it easier to pay down 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 Jiangsu Rongtai Industry can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Jiangsu Rongtai Industry 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

Jiangsu Rongtai Industry's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think Jiangsu Rongtai Industry is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Jiangsu Rongtai Industry has 1 warning sign we think you should be aware of.

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.