We Think Guizhou Zhenhua E-chem (SHSE:688707) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Guizhou Zhenhua E-chem Inc. (SHSE:688707) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Guizhou Zhenhua E-chem

What Is Guizhou Zhenhua E-chem's Debt?

The image below, which you can click on for greater detail, shows that Guizhou Zhenhua E-chem had debt of CN¥2.13b at the end of September 2023, a reduction from CN¥2.22b over a year. On the flip side, it has CN¥1.42b in cash leading to net debt of about CN¥714.4m.

How Strong Is Guizhou Zhenhua E-chem's Balance Sheet?

We can see from the most recent balance sheet that Guizhou Zhenhua E-chem had liabilities of CN¥3.73b falling due within a year, and liabilities of CN¥1.21b due beyond that. Offsetting these obligations, it had cash of CN¥1.42b as well as receivables valued at CN¥2.45b due within 12 months. So its liabilities total CN¥1.06b more than the combination of its cash and short-term receivables.

Given Guizhou Zhenhua E-chem has a market capitalization of CN¥6.98b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

While Guizhou Zhenhua E-chem's debt to EBITDA ratio (2.9) suggests that it uses some debt, its interest cover is very weak, at 1.4, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Guizhou Zhenhua E-chem saw its EBIT tank 92% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Guizhou Zhenhua E-chem's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Guizhou Zhenhua E-chem's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Guizhou Zhenhua E-chem's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Guizhou Zhenhua E-chem's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Guizhou Zhenhua E-chem you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.