We Think Kunshan Kinglai Hygienic MaterialsLtd (SZSE:300260) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Kunshan Kinglai Hygienic Materials Co.,Ltd. (SZSE:300260) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Kunshan Kinglai Hygienic MaterialsLtd

How Much Debt Does Kunshan Kinglai Hygienic MaterialsLtd Carry?

As you can see below, at the end of March 2024, Kunshan Kinglai Hygienic MaterialsLtd had CN¥1.56b of debt, up from CN¥1.03b a year ago. Click the image for more detail. However, it does have CN¥406.5m in cash offsetting this, leading to net debt of about CN¥1.15b.

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

The latest balance sheet data shows that Kunshan Kinglai Hygienic MaterialsLtd had liabilities of CN¥2.15b due within a year, and liabilities of CN¥528.3m falling due after that. Offsetting this, it had CN¥406.5m in cash and CN¥811.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥1.46b more than its cash and near-term receivables, combined.

Since publicly traded Kunshan Kinglai Hygienic MaterialsLtd shares are worth a total of CN¥8.79b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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

With net debt to EBITDA of 2.7 Kunshan Kinglai Hygienic MaterialsLtd has a fairly noticeable amount of debt. But the high interest coverage of 7.3 suggests it can easily service that debt. Importantly, Kunshan Kinglai Hygienic MaterialsLtd's EBIT fell a jaw-dropping 23% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kunshan Kinglai Hygienic MaterialsLtd'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Kunshan Kinglai Hygienic MaterialsLtd burned a lot of cash. 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

On the face of it, Kunshan Kinglai Hygienic MaterialsLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Kunshan Kinglai Hygienic MaterialsLtd's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Kunshan Kinglai Hygienic MaterialsLtd (of which 1 is potentially serious!) you should know about.

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.