Kunshan Kinglai Hygienic MaterialsLtd (SZSE:300260) Takes On Some Risk With Its Use Of Debt

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 can see that Kunshan Kinglai Hygienic Materials Co.,Ltd. (SZSE:300260) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Kunshan Kinglai Hygienic MaterialsLtd

What Is Kunshan Kinglai Hygienic MaterialsLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Kunshan Kinglai Hygienic MaterialsLtd had debt of CN¥1.62b, up from CN¥1.43b in one year. On the flip side, it has CN¥458.1m in cash leading to net debt of about CN¥1.16b.

How Strong Is Kunshan Kinglai Hygienic MaterialsLtd's Balance Sheet?

According to the last reported balance sheet, Kunshan Kinglai Hygienic MaterialsLtd had liabilities of CN¥2.32b due within 12 months, and liabilities of CN¥553.8m due beyond 12 months. Offsetting these obligations, it had cash of CN¥458.1m as well as receivables valued at CN¥994.0m due within 12 months. So its liabilities total CN¥1.42b more than the combination of its cash and short-term receivables.

Given Kunshan Kinglai Hygienic MaterialsLtd has a market capitalization of CN¥11.1b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Kunshan Kinglai Hygienic MaterialsLtd has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.4 suggests it can easily service that debt. Unfortunately, Kunshan Kinglai Hygienic MaterialsLtd saw its EBIT slide 3.3% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Kunshan Kinglai Hygienic MaterialsLtd 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Kunshan Kinglai Hygienic MaterialsLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Kunshan Kinglai Hygienic MaterialsLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest cover is relatively strong. Taking the abovementioned factors together we do think Kunshan Kinglai Hygienic MaterialsLtd's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Kunshan Kinglai Hygienic MaterialsLtd is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

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.